Banks Need Caps on Loans, Rates

Any real reform of the regulation of commercial banks must be based upon restoring the industry's profitability.

Restoring the profitability of insured banks is essential not only to the shareholders of insured banks but also to the public at large.

Capital is the primary buffer to protect well-run banks and ultimately taxpayers from losses by the Federal Deposit Insurance Corp. that are incurred by poorly run depositories. Capital, though, turns out to be just another name for profitability. Without profitability, banks cannot be safe depositories, nor can they take normal credit risks.

Premium Increase a Hazard

Indeed, the lack of profitability of weak banks threatens all banks' profits because of potentially ruinous increases in deposit insurance premiums.

Based upon my discussions with bankers, it seems clear that banks are doing everything they can to restore the profitability of their institutions. Consequently, banks are hard at work cutting costs, working out problem loans, and widening the spreads between loans and deposits. Yet, it is still difficult for banks to raise the capital they need.

Equity investors are still skittish. As of the end of 1990, the average equity dollar invested in a bank was being valued at only about 35% of the value of a dollar invested in the S&P 500. Even with the rebound in bank stock prices this year, most bank stocks trade below their book values.

Key Ratios Decline

During the 1980s, the industry's annual earnings grew at a mere 3.1% compounded. During the same period, the banking industry's return on equity declined dramatically, from about 13.5% to about 8% -- a decline of more than 40%.

Moreover, the industry's returns are highly risky; by 1990 loan losses were averaging about 130% of earnings, in contrast to less than 25% in 1980. The stock market's dislike of bank equities is understandable when one looks at the lack of profitability combined with the riskiness of the industry's returns.

Investors will warm to bank stocks when profitability returns. The fundamental source of the profitability problems of the industry is a broken regulatory system.

Flaws Caused by Government

Specifically, the health and profitability of the commercial banking system has been undermined by two great flaws in the marketplace. These flaws were created in 1982 when the federal government removed the ceiling on interest rates payable on bank and thrift deposits but did not simultaneously reform the deposit insurance system.

By allowing the highest bidder to raise U.S. government guaranteed funds, we encouraged banks and thrifts to give depositors returns far in excess of risk. This can be called the deposit anomaly. Overbidding for deposits channeled funding to weak banks and thrifts that then lent to borrowers on overly generous terms and conditions. This can be called the credit anomaly.

The deposit anomaly undercuts the ability of well-run institutions to take deposits profitably, and the credit anomaly undercuts the ability of strong lenders to extend credit on prudent terms.

Premiums Have Soared

Moreover, the failure of weak institutions has led to massive increases in deposit insurance premiums, with further increases likely as more and more weak institutions continue to fail.

Finally, more and more capital will be demanded by regulators even though most well-run banks, without high-risk loan portfolios, are already well capitalized relative to their risks. Without truly reforming the deposit and credit anomalies, it seems unlikely that the industry will ever be able to restore its profitability.

While the Treasury Department's reform proposals move us in the right direction, they do not go far enough in correcting the deposit and credit anomalies.

Too Heavy a Hand

Specifically, they rely too heavily on more regulation and on putting depositors at risk. The path of tighter regulation shifts the decision about who gets credit and who does not to the government, as well as greatly increases the regulatory burden. Moreover, regulators are always going to be a step behind the market.

Putting depositors at risk, while appealing in concept, is impractical. Yes, the discipline of the free market causes investors to weigh risk-return tradeoffs carefully. Unfortunately, this approach will not work for banks and thrifts because depositors are not investors. Depositors want both safety and liquidity.

Depositors do not trade off risk and return. If there is any real risk, all depositors want all of their money at the same time. Throughout the history of banking, so-called market discipline from depositors is another name for bank panics. The mistake we made in 1982 was giving depositors not only safety and liquidity but high rates as well. In other words, we treated depositors as if they were investors.

A Different Direction

I think there is a better way of correcting the deposit and credit anomalies. I call it core banking reform. Stripped to its essentials, core banking is nothing more than the Treasury's modernization plan with two critical modifications: placing a flexible interest-rate ceiling on deposits in insured institutions, and reducing the legal lending limit for large insured banks.

The flexible ceiling would be tied to Treasury rates of a similar maturity. For example, the maximum rate that could be paid for a six-month deposit would be tied to the six-month Treasury rate. A one-year certificate would be tied to the one-year rate.

The reduced lending limit would be designed to prevent banks and thrifts from becoming overexposed to large wholesale loans with complex risks such as commercial real estate loans, highly leveraged transaction loans, and developing-country loans.

Impact on Larger Banks

Under the core banking proposal, banks with less than $100 million in equity would be largely unaffected, but large insured banks with more than $100 million in equity would be able to lend only 2% of their equity above the first $100 million to a single borrower. This approach would also cause large banks to maintain better-diversified loan portfolios.

These reforms would essentially limit the activities of insured banks to those that the deposit insurance system was formed to protect. Other activities, including capital markets activities and large, high-risk lending activities would be forced out of the insured banks and into uninsured subsidiaries of financial service holding companies.

This approach would essentially force people with funds to decide whether they are depositors or investors. Depositors would know their funds were safe but would earn lower returns.

Higher Rates for Investors

Investors would not be insured but would earn higher rates. Small, high-quality borrowers would still borrow from banks. Large, high-risk borrowers would have to seek financing from finance companies or the equity markets, or from some other noninsured banking source.

While the impact of these reforms on the bank profits and the flow of funds is hard to estimate, it is possible to make a rough guesstimate. I believe that enacting core banking reforms, in concert with modernizing the financial system as the Treasury and some members of Congress have proposed, can add some $20 billion to the pretax profits of insured banks.

One major source of profit improvement comes from reducing loan losses from the 1.4% rate of 1990 to the 0.4% rate of 1980. For purposes of comparison, the average rate of loan losses to loans from 1948 to 1982 was 0.25% of loans. If the loan-loss rate can be brought down to the 0.4% rate of 1980, the savings would amount to roughly $20 billion a year.

Some Money Would Flow Out

We also estimate that some $12.5 billion of income would be lost because some assets would no longer be on insured banks' balance sheets, so the net profit improvement would be only $7.5 billion. In actuality, most of this "lost" $12.5 billion of income would still be earned by separately capitalized uninsured affiliates of the core bank.

There would be about half a percentage point of improvement in spreads on the some $600 billion of small certificates of deposit that would remain in the system because of the flexible deposit ceiling. These increased deposit spreads would increase profitability by another $3 billion.

Finally, the full economic rationalization of the industry, triggered by McFadden Act repeal, could save roughly $10 billion of the noninterest expenses of the largest 125 bank holding companies engaged in interstate banking today. These banks currently have some $75 billion in noninterest expenses, so this would represent a reduction of some 13% of noninterest operating costs.

The absolute assets of financial holding companies owning insured banks would be relatively unchanged since most of the movement of funds would be from insured banks to uninsured subsidiaries, which would serve to improve the profits of those subsidiaries.

Some of the money that did leak out of the system would go to money market and bond funds managed by affiliated companies.

Core banking reforms would help well-run institutions consolidate weaker institutions, leading to a far healthier, more profitable, more effective commercial banking system.

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