While 1992 was a banner year for bank profits, the statistics on bank lending were fairly weak. Total bank loans increased by only about 0.5%, while holdings of government securities soared almost 14%.
Statistics like these could be seen as support for the view that many borrowers are shut out of the markets by banks that are reluctant to lend, and that the source of the problems is stiffer regulation.
Therefore, there is a lot of interest in finding ways to ease regulations in order to get banks to do more lending, including giving bank regulatory policy itself countercyclical features.
The areas of bank credit that have been especially weak are commercial real estate loans, construction loans, and commercial and industrial loans.
The commercial realty bubble of the 1980s has burst, bringing high vacancy rates, low rents, and high default rates into the 1990s. And problem construction loans at commercial banks for the United States as a whole are running at about 17% of total construction loans. In California, the figure is over 20%.
The list of factors that could explain the weakness in C&I loans over the past few years is long, and I will just touch on a few.
First, demand was no doubt dampened by the relatively slow pace of the recovery. But the weakness cannot be explained by the pace of economic activity alone. For example, innovations like just-in-time inventory management probably have dampened demand for credit.
It also has been suggested that businesses have been retrenching from the debt buildup of the 1980s. Furthermore, many firms have shifted away from short-term financing, including bank loans, and toward bond and equity financing.
The decline in C&I loans also probably reflects a longer-term trend, where banks are competing with other financial intermediaries and the commercial paper market for C&I loans.
These factors suggest that a good part of the weakness in bank lending reflects a variety of adjustments going on more generally in the economy. Of course, the effects of these adjustments may be amplified through feedback from the credit sector to the economy.
But they do not represent shocks on the supply side of bank credit. It is argued, however, that such shocks have come from changes in bank regulation - in particular, capital regulation and a stiffer regulatory stance on so-called character loans.
One of the high-profile changes in capital regulation has been the adoption of the Basel risk-based capital standards.
The principle behind the standards is sound: More capital should be held against riskier investments. The actual implementation of the principle so far, however, only takes account of default risk.
For example, in calculating total risk-adjusted assets, Treasury securities get a weight of zero, home mortgages a weight of 50%, and business loans a weight of 100%.
One might expect this kind of a weighting scheme would naturally lead banks toward Treasuries and away from certain loans. But the empirical evidence is still somewhat puzzling. The Fed's latest "Monetary Report to the Congress" finds very little to link banks' risk-based capital ratios to the growth in their securities.
The report also points out that asset accumulation at credit unions, which are not subject to the Basel standards, has also been concentrated in government securities.
The Leverage Ratio
Other evidence, though, focuses on another important capital ratio - the leverage ratio - that differs from the Basel risk-based standards. This evidence does suggest that capital regulation has had some impact on lending.
The leverage ratio is the ratio of the book value of equity to the book value of assets and is not adjusted for risk. Essentially, it is a supplement to the Basel standards, since they currently take into account only default risk.
Constraints from so-called leverage ratios appear to have been a special problem in New England, where commercial banks took large hits to capital. Some banks in other parts of the country also felt constrained by their capital positions in late 1989 and into the 1990s.
In Fed surveys, for example, banks report that capital constraints are at least part of the reason that they have tightened credit standards. Also, a number of studies find a positive and significant relationship between leverage ratios and bank lending in recent years.
And research done at the San Francisco Fed suggests that the effect of the leverage ratio on lending increased in the 1990s, which is consistent with the greater emphasis on capital regulation in recent years.
In terms of the current situation. capital requirements probably are less constraining, in part because banks have increased capital quite a bit. The aggregate equity-to-assets ratio rose from around 6.5% in late 1990 to 7.5% in late 1992, the highest level since the mid-1960s. This rise has occurred as a result of higher earnings as well as the issuance of new securities.
Character Loans Curbed
Compared with capital regulation, a lot more heat is currently being generated over the issue of so-called character loans. The argument is that examiners are limiting the scope of character loans by requiring more loan documentation, and by putting more emphasis on borrowers' cash flows.
This issue has received a lot of attention. Indeed, a recent policy statement by the federal banking agencies and the Office of Thrift Supervision sets out steps to give well-capitalized banks more leeway in making character loans to small businesses. For my part, I'm not sure how much this will boost lending.
It seems to me that if constraints on character loans were a major factor, then we'd expect to see the weakness mainly at smaller banks, which typically make such loans, and not so much at larger banks, with their centralized loan operations. But the fact is, we have seen weak lending at banks of all sizes.
On the basis of this evidence, it does appear that regulation has had some effect, and that capital regulation in particular has made some difference to the extension of bank credit. The greater emphasis on capital regulation and controlling overall risk in banking does depart from the past, when forbearance was common.
On the margin, the new regulatory orientation could intensify the role of the credit channel in transmitting shocks. This point is at the crux of the public debate over the role of banks in the situation we face now - that is, where many of the negative shocks, such as those I mentioned earlier, seem to have been mainly nonmonetary.
Do you ease bank regulation in the face of high problem loan ratios and reduced creditworthiness of some borrowers to make credit more available? Or do you continue to control overall risk in banking and potentially end up reducing credit to segments of the economy?
My own view is that there are some areas where we clearly need to reevaluate our regulations. The recent joint policy statement on reducing requirements for documentation and real estate appraisals for some loans is a move in the right direction.
Another step that has wide support is to drop the leverage ratio once other aspects of risk are built into the risk-based capital standards.
I can also think of some provisions of the Federal Deposit Insurance Corp. Improvement Act that make for bad policy, such as the attempt to micromanage bank,s by requiring regulators to set operating standards in areas like compensation and information systems. And I do not think the supervisory process should wring all of the risk out of bank lending.
But I do think that there are some very good reasons to stick to our guns on capital requirements. On the theoretical side, recent research suggests that an unregulated, uninsured banking system would be subject to qualitatively the same type of discipline that strict adherence to capital standards provides.
That is, uninsured depositors would require undercapitalized banks to shift their portfolios away from risky assets - like business loans - and toward safe assets.