Bankers resolve complex issues.

How the FDIC, Regulators, and Foreign Banks Affect the Banking Industry

The savings and loan (S&L) crisis was a financial nightmare. The S&L bail out cost American taxpayers an estimated $500 billion and the Federal Deposit Insurance Corporation (FDIC) paid out $45.5 billion to

The FDIC was created in 1933 to prevent a vicious cycle of curtailed spending, deepening financial weakness, and an economic slump by protecting the banking system from runs (the loss of confidence in a bank which can lead to a flight of deposits). Although this is a secure way to protect customers' money and prevent economic chaos, it also relieves depositors of any need to monitor their bank's performance. Insured banks can be engaged in reckless spending, attract depositors, and still get bailed out by the FDIC. Insurance allows banks to operate with much less capital than they would otherwise need; without insurance, the burden would be on banks to impress depositors with their financial strength.

Financial innovation, itself a product of deregulation, makes it possible to imagine a safer, though uninsured, banking system. Uninsured interest bearing deposits would be at a competitive disadvantage against money market mutual funds (MMMFs), which would grow apace.

Fixed claim deposits would still be offered, but the banks would have to back them with more capital and conservative portfolios of safe assets; these accounts would pay little interest. Companies would be able to borrow much less from banks, and would therefore have to raise more finance by issuing debt and equity. This would be a very difficult financial system, to be sure--but one in which risk and return might be better aligned than at the present. (see The Economist, Jan. 12, 1991).

"Think about what happened with some of the thrifts; everyone knew they were going out of business, but no one even needed to take their money out, particularly if the amount was under $100,000, because they knew the government was going to take care of them. These thrifts were paying above market rates to attract money, yet people were getting government insurance. If you really believe in a free market system, you'll allow people to make choices about where they do their banking based on the track record of the banks," said Scott A. Kisting, executive vice president, head of U.S. corporate banking for Norwest Banks, Minneapolis, Minn.

Fdicia Gives Bankers More Paperwork

The FDIC Improvement Act of 1991 (Fdicia), requires federal regulators to tighten their surveillance on banks and not support failing institutions whose tangible equity capital is below 2 percent. It demands that regulatory accounting principles be no less stringent than the generally accepted accounting principles, and burdens banks with new reporting, legal, and auditing costs. Fast action, so the theory goes, will prevent raids on the insurance fund.

Most banks have accepted the 2 percent rule, but they detest Fdicia's costly regulations; some of these restrictions will make weak banks worse. Congress has directed the FDIC to build its insurance fund up to 1.25 percent of insured deposits. Immediate compliance would require the fund to balloon from less than nothing (because reserves that the FDIC has established have given the fund a negative net worth) to $26 billion.

"There's no question that (Fdicia) tightened everyone up and made people think, 'Here's another round of reports that we have to deal with.' You've got a government criticizing banks for not making loans on one hand and criticizing banks for making loans on the other. And then they're surprised at human beings tightening up," said Kisting.

According to Kisting, more market discipline and rewards for quality are keys to unlocking bad lending practices.

"What we ought to have is market discipline; the banks that don't pay attention to good lending practices, won't be around. What the government never really did until recently, is differentiate between high quality institutions and lesser quality institutions. If there was some reward for running your organization in a discipline way, that would work. If I have divisions that received two or three really clean audits in a row, we might go an extra six months before we audit them next time," he said.

Less restrictive lending practices will not help solve the banking problem. What banks do need, said Kisting, is more time to spend with customers and less time worrying about paperwork.

"I don't think it's a case of looser lending practices, but of all the bureaucracy and all the documentation you have to maintain for the regulators. You've got to keep track of almost every conversation you have to make sure you didn't discuss whether or not a loan was involved. I think it has more to do with freeing bankers up to spend time with their customers and prospects.

"We kept logs on our people for two weeks and found that they were spending an incredible amount of time on administrative and clerical functions because of the regulatory burdens banks have. I think that the government can play a role here, not by changing laws, but changing the enactment of existing laws. As banks have become healthier, I have not seen the staffs of the regulators reduced. In order for them to have something to do, they ask you for more information or scrutinize you even closer. It may eventually get to the point where bankers will be too afraid or they won't have time to make loans," Kisting said.

The weaker the bank, the greater its risk to the insurance fund and the more it must pay. These banks, judged objectively by their capital ratios and subjectively by regulators, will pay a 31 cent premium on their insured deposits, while the healthiest banks will pay 23 cents on every $100 of insured deposits. The 8 cent difference may not seem like much, but it can be substantial.

Consolidation--Bank on It or Bust?

One drawback from Fdicia will be a surge in the consolidation trend that, since 1985, has reduced the number of banks from 15,000 to 12,000. Some already struggling banks are going to be driven into the 2 percent territory and fail; this means more calls on the deposit insurance fund. The FDIC has estimated that it will seize 100 to 125 banks in 1993.

Kisting believes consolidation is a good plan. "Although market consolidation is taking place, there is tremendous over capacity when you compare the number of U.S. banks to the number in Japan or Europe; there's no reason not to consolidate. The small banks worry about having to look for their niches. They should know that there is plenty of market for any well-run financial institution if they take care of their customers. We don't have any advantage over the small banks, unless our people act like small bankers in local communities and treat the customer accordingly," Kisting said.

Many bankers see mergers, especially banks with shared markets, as the key to making the industry stronger, more efficient, and better able to fight domestic and foreign competitors. However, the average bank merger in the 1980s did not cut costs or raise productivity, and actually made the combined bank slightly less profitable, according to a study by Economist Aruna Srinvasan of the Atlanta Federal Reserve. Although there was a decrease in salaries and branch costs in the merged banks, the savings were offset by increases in expenses to cover advertising and amortization of goodwill acquired in the takeover.

What Regional Banks Can Offer

Banks profit only if they can charge a markup between their cost of funds and what the borrowers have to pay for money. The reason for the markup is an "information advantage"--banks know more about who the good borrowers are, according to bank regulators.

Local and regional banks, lending to borrowers whose names aren't well known in the money markets, can get such a markup. The market won't know the $100 million food company, so the banks can charge a premium for interposing itself between the company and the credit market. Local or regional banks will know their customers better than money center banks and the regulators.

"Regional banks usually offer a wider range of full service banking. A lot of local banks say they have letters of credit, but typically they have a correspondent regional bank which performs the service for them," said Dev Strischek, executive vice president of credit administration for Barnett Bank of Palm Beach County, West Palm Beach, Fla. "Regional banks also offer national banking services where they help U.S. corporations underwrite commercial paper with stock up lines in large amounts that a community bank could not possibly match," he said.

Tight Lending Affected Commercial Real Estate

"I think the credit crunch was more a commercial credit crunch than a consumer credit crunch. As far as housing loans go, it wasn't so much that some people weren't qualified or the property was not available, it was that people weren't economically motivated to obtain a loan. It's just been within the past year or so that interest rates fell enough to get home buyers interested in buying and homeowners in refinancing," Strischek said.

"On the commercial side, the deflation of commercial value has definitely put a crimp in commercial real estate lending because a lot of our lending here is for businesses to buy warehouses or expand their business house facilities. Suppose you made a loan on an appraisal that said the warehouse was worth $500,000 and a couple years later the value sunk so low that it's only worth $300,000. You originally agreed to a 75 percent loan-to-value. A 75 percent loan-to-value would have extended $375,000, but with a new appraisal at $300,000, you are now $75,000 over the value. If the loan is up for renewal, you have to advise the borrower that your 75 percent loan-to-value policy restricts you to a renewal loan for only $225,000. A loan in excess of loan-to-value policies is likely to be criticized and possibly require the bank to set aside higher reserves against the loan. The reserve hurts the bank's earnings unless the bank raises the rate to offset the reserve, which is usually not practical. The customer is not able to borrow more money on the collateral, and instead, he has to make larger-than anticipated principal reductions just to renew the loan," he said.

Will Less Restrictive Lending Practices Mean Defaulted Loans?

It depends, according to Strischek.

"No, not unless we're compelled to extend loans to people who we would otherwise not lend to. When they say character loans, some people translate that as we won't be asking for personal financial statements and tax returns; that's wishful thinking. We have to be able to prove that the borrowers have the reserves and the income to repay their loans. Our proof is based on the financials and returns. On the other hand, we do have borrowers who have paid their loans on time over the years.

"We might not have enough sophisticated information to show the customer's ability to pay every year; maybe they are able to cover their principal and interest payments by 95 percent this year instead of 100 percent in previous years. If the customer has paid you for five years, on time, and never been delinquent, we have found it hard to rely on that experience in these close call situations. Now the bank examiners seem to be saying that they are more comfortable with our judgment and that is a positive development for good customers and prudent bankers," Strischek said.

Kisting shares Strischek's optimistic lending outlook. "Banks are very interested in being in the lending business and getting some high quality assets on their books, particularly as yields have come down on their investment portfolios. I think that the availability of credit from a balance sheet standpoint of banks, in terms of banks' liquidity and capital ratio is very strong, and banks are clearly interested in making loans.

"There is no question that over the course of three to four years, with a lot of encouragement from regulators, banks tightened up their credit standards. In some cases, that was very appropriate, and in other cases, some banks may have overreacted. But there was no question that there needed to be more discipline in the commercial lending practices of banks. There were banks in which commercial loans, which were the key products, were not profitable. Banks did put a lot more discipline into their lending practices, but I don't think any good bank wanted to go out of the lending business. While banks want to make all the good loans they can, a lot of this is driven by the economy. A lot of commercial lending in the '80s was driven by commercial real estate growth, and now no one is pursuing commercial real estate," Kisting said.

Foreign Banks and Non-Bank Lenders Are Capturing a Percentage of the Market

Banks across the U.S. have sharply reduced their lending to businesses, prompting a host of foreign banks and non-bank lenders to step in to fill the credit gaps. The rush of new players into the lending market raises questions about whether many American banks will recapture this lucrative business once they decide to resume lending.

"There are some brokerage operations getting into the banking business, particularly in the middle-market banking business--companies like Merrill Lynch who have formed teams in their offices to go after middle-market lending opportunities with the idea they'll also get the capital market opportunities," Kisting said.

The total foreign share of banks in the U.S. syndicated market is 48.4 percent. The giant, with 5 percent of total foreign activity, is the Dutch ABN AMRO Bank N.V. with assets totaling $250 billion. Citicorp is the only U.S. bank that can come close, with $214 billion in year-end assets.

Companies that wish to expand overseas are also finding it difficult to receive credit from American banks simply because most of them do not have the international capabilities. According to the Export-Import Bank, the official federal export credit agency, out of 12,000 U.S. banks, about 25 now make export loans broadly available to U.S. companies.

U.S. exporters may be losing overseas sales because they lack financing and those hardest hit have been small and medium-size exporters; probably the ones with the greatest needs. Some exporters believe that many bankers do not get involved in trade finance because they do not understand the business or are leery of substantial losses. But U.S. banks have lost more on domestic real estate and commercial and consumer loans that on all foreign loans put together, according to the FDIC.

At-a-Glance

* Some say the FDIC may be a system whose time has come and are looking for alternatives.

* While most bankers have no quarrel with insurance requirements, the regulators and paperwork give them cause for concern.

* Bankers are predicting a more favorable lending outlook now that their commercial real estate practices are "more disciplined."

* U.S. banks face stiff competition from foreign banks.

According to the Federal Reserve, there are three reasons why bank mergers don't make sense.

1. Efficiency is difficult to show.

Banks that merged in the '80s showed no significant gains in operating efficiency. Federal researchers say the industry would gain more by improving operations at inefficient banks than by combining banks to cut overlap and costs.

2. Benefits are tough to predict.

Federal researchers found that even efficient banks had a hard time generating costs savings after buying another bank. Eliminating market overlap through mergers didn't produce bigger savings, either.

3. Bigger doesn't mean better.

Banks don't get more efficient as they get larger. The big banks that are now merging are already larger than the most cost-effective size, say researchers. Although a merger occurs, some banks do not consolidate their departments, which means more waste.

There was a time when big banks were needed to serve big customers such as Harvester and Caterpillar, Swift and Armour, and General Mills, but companies that size don't need banks anymore. They can borrow more cheaply in the commercial paper market.

Kim Howard is the associate editor of Business Credit.