Speculation has grown recently that the banking industry is facing a "December surprise" -- that is, a sudden spike of bank failures after the presidential election. At a Senate Banking Committee hearing last week, three regulators and four industry observers agreed there would be no surprise.

But one of the witness, author Martin Mayer, said the industry should not take much comfort from that. Excerpts from his testimony follow.

There are two main reasons why we won't have a rash of bank failures in December, and neither of them provides much hope for the medium-term stability of the sector.

The first reason is that the Fed has single-mindedly targeted the profitability of banks as its policy objective for two years, encouraging them to exploit the opportunities offered by the steepest yield curve we have ever seen in this country.

The thought was that, if the banks felt profitable, they would make loans, helping American business out of the slough of despond.

In practice, the strategy backfired: Banks that could make money without making loans did so. And the governments and insured-mortgage-paper parts of banks' portfolios ballooned, while the commercial-and-industrial-loan portfolios shrank.

Fed Making It Worse

Banks cut their expenses by laying off loan officers. The Fed made a bad scene worse by assigning a zero risk weighting to government bonds, and a 20% risk weighting to Fannie Mae and Freddie Mac paper, for purposes of capital adequacy.

Thus, a bank needed $8 of capital to back every $100 of loans, but only $1.60 to back the ownership of $100 of collateralized mortgage paper, and none at all to hold government bonds -- at a time when a steep yield curve made it monumentally profitable for a bank to borrow short and lend long.

Even after you factor in the leverage capital ratios, it's still $3 for government bond or mortgage paper as against $8 for business loans.

As a return on capital, a commercial loan today requires 10.5% interest, 450 basis points over prime, to match the apparently safe, totally cost-free return in a five-year note, let alone a 30-year bond.

Rules by Mickey Mouse

Of course, the safety is illusory. The Fed has proposed letting banks monitor their own interest-rate risk and set aside capital against it, in one of the purest Mickey Mouse regulations ever written.

The second reason there will be no massive December surprise is that Treasury Under Secretary John Robson has very effectively leaned on the bank examiners to revise their already permissive rules for the valuation of commercial real estate loans and owned properties -- and to let banks create fake capital by claiming that these loans and investments are worth just about twice their real value.

When First Chicago and Fleet Financial decided to take the hit the other day, they wrote down the commercial real estate portfolio by roughly 50% from book value -- admitting they had been carrying most of it at full book until that moment. Others are no better. Indeed, others are presumptively worse.

As the mandatory actions in the Federal Deposit Insurance Corporation Improvement Act of 1991 are triggered by insufficient capital, overvaluation of foreclosed real estate and mortgage loans slips the trigger.

When the Bad News Starts

It is not impossible, however, that we will begin seeing some surprise as early as January and all but certain that we will have some bad news in late 1993 and 1994, when interest rates turn up again.

The January problem is the accountants, who are being sued to beat the band for their willingness to discard what their clients used to call "rigid professionalism" when certifying the statements of BCCI, Lincoln Savings, Western of Dallas, Western of Phoenix, and various other savings and loans.

These lawsuits have powerfully concentrated the minds of the specialists in bank and thrift accounting, and they may not be willing to accept all the valuations that are O.K. with the Robson-tormented examiners.

Banks that are showing improved results because of fewer writeoffs, in other words, may be compelled by their outside auditors to take more writeoffs in the fourth quarter and for the year as a whole.

Rate Policy's Bite

The problems of 1993 and 1994 will grow out of the successes of this year, for the longer-term paper banks are holding will go down in value pretty fast after rates turn.

The banks are mostly not very nimble, and the people who have been selling them the hedges they think will protect them are so much more nimble than the bankers that the risk-control devices of which banks now boast may well prove to have heightened rather than diminished the risks.

Banks with big off-balance-sheet nominal exposures may be especially badly hit. As E. Gerald Corrigan of the Fed of New York told the New York State Bankers in January, you can't manage what you don't understand. One is reminded of a lovely piece of Rudyard Kipling doggerel:

"There are four and twenty ways

Of constructing tribal lays,

And every single one of them is right."

Similarly, swaps can be marked to market by four different procedures, which give four different results. And at present, there is no reason why the swaps trader (who is, after all, remunerated by results) cannot value them one way on Tuesday and another way Thursday.

Liens Against Capital

Still, the operating profit being booked this year are real money, green on one side and gray on the other, and their retention does create a somewhat greater capital cushion than the banks have had in recent years.

What is important for everybody to keep in mind is that in many instances this capital does not really belong to the stockholders: It wouldn't be there without the put option on the assets that the FDIC has given the owners of the bank. And the deposit insurance funds and the Fed have a lien on it.

Jim Grant, the editor of Grant's Interest Rate Observer, said the other day that he looked upon the examiners permanently stationed at Citibank a he looked at the Marine guards at our embassies: Both are guarding the taxpayers' property.

That's a little much as a generalization, for there are many strong, socially and economically useful banks in the United States, most of them bearing names little known outside their own cities or states.

Bias Toward Overcapacity

But with all the errors and poor information in the recent study published by the Washington Post Co. on the FDIC fund's prospects [see Required Reading, beginning on page 21], its authors are right on the larger picture: The long-term prospects of the dinosaur banks continue to be like the long-term prospects of the dinosaurs after the weather changed.

There is in the end a significant analogy between the S&L disaster and the banking problem. Deposit insurance and other safety nets to protect lenders to banks generate overcapacity in all depository institutions.

In 1981, when I became a member of Ronald Reagan's National Commission on Housing, the S&Ls had just under $800 billion in assets, and a declining social function.

That was so because housing paper was being held increasingly by contract thrifts -- pension funds, insurance companies, and mutual funds -- rather than in depository institutions.

By 1989, when government stopped solving the problems of the S&Ls, they had almost $1.4 trillion in assets. It is scarcely surprising that a high fraction of those assets were worth less than the price at which they were booked.

The fundamental truth about our banking system is that there simply aren't enough good bankable assets to cover the $3.5 trillion in bank liabilities.

Wrong End of the Cycle

The problem, in a nutshell, is that the big banks are caught on the wrong side of a secular trend.

Information-poor societies need banks; information-rich societies need markets. The spread on safe loans in information-rich societies is not large enough to support the apparatus of banking, and bankers are not much good at anything but banking, if that.

We cannot escape the glaring fact that the 1986 tax act knocked at least one-third off the value of commercial real estate, which had been preposterously puffed up by the 1981 tax act -- and that banks over the next four years actually doubled the share of commercial real estate in their loan portfolios.

Policy here must have three lodestones.

* Obviously, we cannot afford a debt deflation.

* We need depository institutions as transmission belts for monetary policy.

* And as the banking system shrinks, we need ways to protect the good borrowers who lose "their" bank and find themselves in the hands of hostile lending officers from an acquiring institution or (even worse) of FDIC bureaucrats who know the one thing you must never, never do is throw good money after bad.

These goals can be reached, by people who know enough to seek them. Let's hope we will get such people in office soon.

Mr. Mayer's most recent book is "Stealing the Market."

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