Despite vastly improved profitability, the U.S. banking industry must overcome severe challenges in order to play its part in revitalizing the economy.

Strict new rules under the Federal Deposit Corporation Improvement Act of 1991 are significantly increasing the industry's capital requirements. The act's restraints will even affect many small banks that have above-average equity ratios, as well as the poorly capitalized banks for which the legislation was designed.

The regulators are thus faced with a dilemma: either to accept the slow growth in lending that results from the new rules or loosen them and risk creating bank credit quality problems in the future.

A Record of Success

The answer to this dilemma may lie in creating a modern version of the Reconstruction Finance Corp., which successfully "resolved" the banking crisis of the 1930s.

One of the fundamental problems facing the U.S. banking system is that the regulators are trying to ensure safe and sound banking through rules that are increasingly detailed, complex, and often in conflict. They are following this course rather than relying on the traditional safeguard for depositors, namely a strong capital position.

While many banks have raised significant amounts of equity, not all have been able to do so.

Burden of Real Estate Loans

Furthermore, many banks remain heavily exposed to loans on commercial real estate.

Yet if small businesses are to serve as an engine of employment growth in the next few years, it will be necessary for the banking system, which is their main source of credit, to be able to lend more freely.

If banks have to cope with commercial real estate writeoffs entirely through earnings, many of them will find their asset growth restricted for the rest of this decade. This situation could be greatly helped if a way could be found to provide banks in need with sufficient long-term capital to ride out the present real estate depression but without delaying the fundamental adjustments that the banking industry must make.

Regulatory Inflexibility

While 1991 FDIC Improvement Act represents a well-intentioned effort to improve the safety and soundness of the banking system, it drastically limits the flexibility of the regulators to help a bank work through its problems.

For example, the Federal Reserve is now prohibited from acting as a lender of last resort unless it can certify that the bank is solvent.

The basic problem is that many banks face an extended period of writeoffs of their commercial real estate mortgage portfolios, and that under the 1991 law, they will face more and more restrictions on their operations as their capital is reduced.

Plunging Lease Income

First, there is the lease roll-over problem, especially for office buildings. Vacancy rates are high in many metropolitan areas and current rents are well under those of three or four years ago.

Thus, many office properties with large mortgages are likely to go bankrupt and the banks holding the mortgages will incur losses over the next several years.

Second, as the U.S. economy recovers, short-term interest rates, which are now at or below the rate of inflation, will rise. Banks will no longer be able to earn "windfall" profits from investing in U.S. Treasuries. With loan growth restricted by the new capital rules, it will be hard to replace these earnings.

Capital Requirements

The small banks face a different kind of problem, one that threatens to restrict their ability to meet the loan demands of their small-business customers. Under the 1991 law, a "well-capitalized" bank must have a Tier 2 capital ratio of 10%. This means that the sum of equity, loan-loss reserves, and subordinated debt must be equal to or greater than 10% of risk-weighted assets.

Indeed, to issue subordinated debt in the public capital markets may well be difficult for banks with less than $500 million in total assets. As a practical matter, therefore, small banks may have to restrict their asset growth to a rate that can be supported by internally generated equity.

That rate may not be sufficient to support the small business growth for a revitalized U.S. economy.

There is a striking parallel between today's commercial real estate problems and the real estate problems of the 1930s. Now, as then, time will be required for real estate values to recover.

A new version of the Reconstruction Finance Corp., to be called perhaps the Federal Financial Capital Corp., could have two main functions:

* Creating a secondary market in the subordinated debt of smaller banks without easy access to public markets.

* Providing temporary capital to capitol-short institutions (commercial and savings banks, and possibly insurance companies).

In the first instance, it would help smaller banks keep pace with the credit needs of their small-business customers. In the second, it would enable banks (and other institutions) whose other operations were profitable to recognize their real estate losses on the balance sheet but continue to hold the properties until sold at a fair price.

Existing bank security holders would end up foregoing dividends and interest in the short-run because the bank would have to pay the Federal Financial Capital Corp. first. In the longer run, however, their investments would have more chance of recovering than if the bank were seized and sold or liquidated.

Less Taxpayer Money

Such an approach would be less costly for the U.S. government, too, since property loses a great part of its value as soon as it is put into a liquidation sale.

Another benefit is that using government funds as capital would support a much larger volume of assets than holding the assets directly, so the government would have to put up less money.

Furthermore, if the dividend rate on Federal Financial Capital Corp. preferred stock were set at one or two percentage points over the yield on five-year Treasury notes, the whole operation could be conducted at a profit.

There is no doubt that some of the 100 largest banks need to consolidate. A good part of the old-fashioned loan business for large companies has evaporated, and there is a need to reduce both costs and capacity.

Continuing to Lend

One advantage of capital infusions from a Federal Financial Capital Corp. would be to enable a bank receiving them to continue operating and making loans to small business and consumers, without being forced to contract its balance sheet to meet capital ratio standards of the 1991 law.

Another advantage would be that capital from this entity would be self-liquidating out of earnings; there is no danger that it would lead to a major expansion in bank credit. In the present climate of the financial markets, it should be possible for a Federal Financial Capital Corp. to obtain some equity capital from private investors, as well as from participating banks.

It could well be patterned after the Federal National Mortgage Association - itself an offshoot of the old Reconstruction Finance Corp. - and issue its own debt securities. How much capital might be needed? Probably between $20 billion and $30 billion, a comparatively small sum by today's federal standards.

The establishment of a Federal Financial Capital Corp. deserves serious consideration. It would go a long way toward rebuilding confidence in the U.S. financial system and to enabling it to play a proper role in the revitalization of the economy.

Substituting capital for overly onerous regulation would allow the discipline of the financial markets to work more effectively. The result should be a lower cost to the taxpayer as well.

Mr. Synnott is the chief economist at U.S. Trust Corp., New York.

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