Federal Deposit Insurance Corporation 

FDIG 

Acting Chi 

Andrew C. Hove, jr. 

Division of Research 

and Statistics, 

Director 

Win, Roger Watson 

Editor 

George E. French 

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Frederick Sr Cams 

Gary S. Fissel 

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Washington, D.C. Z0429. 

Spring/Summer 1994 

Vol. 7, No. 1 

Evaluating the Role of Race in Mortgage Lending 

by David K. Home page 1 

A statistical analysis by the Federal Reserve Bank of Boston of mortgage-lending patterns in the 

Boston area suggests that mortgage lenders discriminated against minority applicants. Examination 

of the loan files that comprised the statistical data uncovered a number of factors that may 

systematically bias the model's estimates of the race effect. As a consequence, it cannot be 

determined whether the higher rejection rates observed for minority applicants reflect these factors 

or result from lending discrimination. 

Risk Measurement, Actuarially-Fair Deposit Insurance Premiums and the 

FDIG's Risk-Related Premium System 

by Gary S. Fissel page 16 

The author compares the FDIC's risk-related premium system with independent risk classifica 

tions derived from a proportional hazards model (PHM). The PHM estimates actuarially-fair 

insurance premiums based on econometric estimates of expected time-to-failure. The paper 

concludes that the FDIG's relative risk rankings are generally consistent with those of the PHM as 

well as with historical failure rates. The premium rate spread between high- and low-risk institu 

tions, however, is considerably narrower than what is suggested by the PHM. 

Bank Powers and the Separation of Banking from Commerce: 

An Historical Perspective 

by Christine E. Blair page 28 

The author provides an historical perspective on bank powers and the lines of separation between 

banking and other activities. This separation has taken the form of both prohibitions on bank 

activities and affiliations, and "firewalls" intended to prevent inappropriate flows of capital, funds 

and information between affiliates. The scope of permissible bank activities has evolved over the 

course of American banking history, changing in response to economic incentives, technological 

innovations and political interests. As such change is likely to continue, the debate on appropriate 

lines of separation between banking and other activities should remain lively. 

Recent Developments Affecting Depository Institutions 

by Benjamin B. Christopher page 39 

This regular feature of the FDIC Banting Review contains information on regulatory agency actions, 

state legislation and regulation, and articles and studies pertinent to banking and deposit insurance 

issues. 
Mortgage-Lending Bias 

Evaluating the Role of Race 

in Mortgage Lending 

by David K. Home* 

The controversy concerning 

racial discrimination in mort 

gage lending has intensified 

since the release of the 1990 Home 

Mortgage Disclosure Act (HMDA) 

data. Although data on mortgage lend 

ing have been collected since HMDA 

was enacted originally in 1977, lenders 

were not required until 1990 to report 

applicant characteristics such as race, 

ethnicity, sex, age and income. The 

aggregate data reveal large discrepan 

cies in loan outcomes by race. Ap 

proximately 35 percent of black 

applicants, 28 percent of Hispanic ap 

plicants, and 24 percent of American 

Indian/Alaskan native applicants 

weredenied mortgage loans in 1991. 

versus the 16 percent rejection rate 

for white applicants.1 These differ 

entials persisted when rejection rates 

were compared for applicants within 

income categories. Similar patterns 

were observed in the 1990 data as 

well.2 To many observers, the large 

and persistent difference in rejection 

rates provides compelling evidence 

that mortgage- lending institutions dis 

criminate against minority applicants. 

Numerous federal regulatory 

agencies have responsibility to ensure 

that banking institutions comply with 

laws that expressly prohibit lending 

discrimination, including the Fair 

Housing Act and the Equal Credit 

Opportunity Act. Compliance exam 

inations, which are conducted by 

bank regulators on a regular basis, are 

one means of evaluating whether 

lenders are extending credit in an un 

biased manner. The HMDA data are 

one source of information that is eval 

uated in the compliance examination 

process. HMDA reports are exam 

ined to determine whether the num 

ber of minority applications appears 

reasonable, given the demographics 

of the lender's market area. Compli 

ance examiners also inspect the mi 

nority rejection rates to determine 

whether these may indicate disparate 

treatment on the basis of race or 

ethnicity. If evidence suggests that 

further investigation is warranted, ex 

aminers may analyze different aspects 

of the lending program, such as 

whether the types of products offered 

are appropriate to meet the needs of 

the community and whether these 

products are marketed to reach all 

segments of the community. Compli 

ance examiners also scrutinize in 

dividual loan application files to 

determine whether applicants are 

treated fairly without regard to race, 

ethnicity, or other protected factors. 

Approximately 90 percentof bank 

ing institutions receive compliance 

ratings of satisfactory or better, appar 

ently indicating that the substantive 

provisions of the antidiscrimination 

regulations are satisfied.3 Rarely have 

compliance examinations provided 

sufficient data to support a conclusion 

chat an institution has engaged in dis 

criminatory lending practices. Thus, 

the compliance ratings given by bank 

regulatory agencies are not consistent 

with widespread racial discrimination 

suggested by the HMDA data. 

In order to explore this inconsis 

tency, the Federal Reserve Bank of 

Boston (hereafter referred to as the 

Boston Fed) surveyed lending insti 

tutions in the Boston area to supple 

ment the 1990 HMDA data. Many 

valid underwriting criteria that lend 

ers consider when evaluating poten 

tial default risk, such as assets, debt, 

'Economist, Division of Research and Sta 

tistics, FDIC. The author is indebted to George 

Benston, George French, Arthur Murton, Lynn 

Nejezchleb, and Win Roger Watson for iheir 

helpful comments and suggestions. The author 

also thanks Charles Haddad foi assistance re 

garding on-site visitations, the many examiners 

who devoted considerable time and effort to 

examining and documenting information in the 

loan files, Jimmy Loyless and Paul Weichman 

who supported the participation of staff in the 

Boston regional office, and Steven Guggenmos 

who provided excellent research assistance. 

Asian/Pacific Islander applicants, in con 

trast, experienced denial rates (18 percent] 

nearly equal to those of white applicants. These 

statistics are based on the final 1991 HMDA 

data for owner-occupied housing, excluding 

multifamily units for the purpose of this com 

parison. 

For an extended analysis of the preliminary 

HMDA data in 1990 and 1991, see Glenn B. 

Canner and Dolotes S. Smith (1991), and Can

nerandSmith(1992). 

3In 1992, 90 percent of the 5,602 banking 

institutions examined for compliance with CRA 

received outstanding or satisfactory ratings (ac

cording to the July 20, 1993 American Banker, 

referencing statistic? repotted in the 

CRA/HMDA Updare), while 58 received the low 

est racing of "substantial noneompliance." In 

the first half of 1993, 93 petcent of the institu 

tions received outstanding or satisfactory ratings 

and 0.4 percent (ten out of 2,606 lenders) wete 

judged to be in substantial noneompliance. 
FDIC Banking Review 

net worth, credit history, and employ 

ment record, are not reported under 

HMDA. If one or more excluded fac 

tors are correlated with race, different 

rejection rates observed across racial 

groups would not imply necessarily 

that race is the causal factor. For ex 

ample, lack of accumulated wealth is 

a primary barrier to homeowners hi p. 

Net worth is substantially different 

across demographic categories: the 

median net worth of families headed 

by whites in 1989 was $58,500, com 

pared to $4,000 for families headed by 

nonwhites and Hispanics.4 The Bos 

ton Fed study tried to determine 

whether factors such as these could 

explain the observed differences in 

mortgage loan denial rates. 

Data were provided by all lending 

institutions in the Boston area that 

had a minimum of 25 mortgage appli 

cations in 1990. The Boston Fed re 

quested information on all black and 

Hispanic applicants and a sample of 

the white applicants. Altogether, data 

on 38 additional variables were col 

lected, representing "all the financial, 

employment, and demographic infor 

mation that lenders may include in 

their determination to approve or 

deny a loan application." After ac 

counting for these factors, the Boston 

Fed found that minority applicants 

were still more likely to be rejected 

than were white applicants.5 

The Boston Fed report was the pri 

mary motivation for investigations by 

Massachusetts' Attorney General and 

the U.S. Department of Justice, and 

prompted probes by virtually all of the 

federal regulatory agencies responsi 

ble for enforcing antidiscrimination 

statutes. FDIG staff reviewed the 

loan applications at FDIC-supervised 

institutions that were included in the 

Fed study. Compliance examiners 

scrutinized the Boston Fed data and 

examined individual mortgage loan 

files in order to identify institutions 

that may have discriminated against 

minority applicants. In addition, in 

formation was collected that might 

explain why past examinations had 

not detected lending bias. 

The purpose of this paper is to in 

vestigate the paradox raised by the 

different conclusions arising from the 

two different approaches. The meth 

odology and findings of the Boston 

Fed study are evaluated in light of the 

FDIC file reviews and other analyses. 

Because the Boston Fed database and 

the results of the statistical models 

were available to bank examiners to 

use in selecting loan files for further 

examination, the predictions of the 

statistical model for specific appli 

cants could be compared to the data 

in the applicants' loan files. This 

paper evaluates whether the conclu 

sions of the Boston Fed study are sup 

ported by evidence from the loan 

files. The paper does not address the 

broader question of whether racial 

lending discrimination exists. Racial 

discrimination may take many forms, 

such as the prescreening of applica 

tions, that may not be apparent in an 

analysis of loan outcomes. 

This paper concludes that it is not 

possible to establish whether the race 

effect identified in the Boston Fed 

study reflects racial discrimination by 

lenders, or results from methodologi 

cal problems with the statistical ap 

proach. In particular, there are four 

problems with the statistical model 

that are discussed in this paper: (1) 

The Boston Fed data were subject to 

a substantial number of errors; (2) the 

independent variable in question, 

loan outcome, in certain circum 

stances did not accurately reflect ei 

ther lender decisions or the ability of 

an applicant to purchase a home; (3) a 

number of important factors influenc 

ing the ability to purchase a home 

were misspecified or insignificant; 

and (4) other aspects of the model 

specification did not adequately re 

flect the underwriting process. More 

research is required to determine 

whether statistical models corrected 

for the deficiencies described in this 

paper can be useful in detecting racial 

lending discrimination. 

The first section of this paper dis 

cusses the Boston Fed study docu 

mented in Munnell et al The next 

section describes the applicant file ex 

aminations conducted by FDIC staff, 

reports the findings, and enumerates 

problems with the statistical model. 

Subsequently, the model fit is dis 

cussed. The final section contains the 

conclusions and policy recommenda 

tions. 

Background and Description 

of the Boston Fed Study 

The HMDA data reveal significant 

differences in rejection rates across 

racial and ethnic groups, although the 

data provide insufficient detail to 

identify the factors responsible for 

these differences. Mortgage lenders 

are required to report information on 

such factors as the race, sex and in 

come of applicants, the amount of the 

loan and price of the property, the 

type of loan, loan purpose, type of 

property, occupancy status, the cen 

sus tract location of the property, and 

loan outcome. However, most of the 

primary factors that are evaluated by 

underwriters are not reported, includ 

ing such characteristics of applicants 

as liquid assets, net worth, credit his 

tory, and employment experience. 

Property characteristics such as ap 

praised value and physical condition 

also are not reported. 

Analysis of HMDA data and exam 

ination of loan files are a standard part 

of the compliance examination pro 

cess for bank regulatory agencies. In 

theory, the ability to access all of the 

data in loan files should help to iden 

tify instances of lending discrimina 

tion. In practice, it is generally not 

possible to locate files of white appli 

cants with characteristics that are suf 

ficiently similar to the characteristics 

of denied minority applicants to sup 

port a finding of racial discrimination, 

especially at institutions with a small 

number of minority applicants. When 

dissimilar files are compared, the de 

termination of how much weight to 

give different applicant attributes re 

quires the application of subjective 

judgment by examiners who may 

have limited expertise in mortgage 

Statistics are from the Survey of Consumer 

Finances, discussed in Kennickell and Shack

Marque2(1992). 

sMunnell, Browne, McEneaney and Too

tell(1992),p. IS. 
Mortgage-Lending Bias 

underwriting. As Munnell (?/#/. main 

tain, "under existing examination 

procedures, examiners can be ex 

pected to uncover only the most fla 

grant abuses."6 The use of a statistical 

approach to examine the influence of 

race has several potential advantages 

as compared to existing examination 

procedures. Statistical analyses may 

be applied to investigate broad lend 

ing patterns, and the weights that are 

assigned to the important factors used 

in the underwriting process can be 

estimated using a statistical model. 

The Boston Fed incorporated addi 

tional variables and applied a statisti 

cal methodology to control for 

important factors that influence loan 

underwriting. 

The Boston Fed surveyed mort 

gage lenders in the Boston area to 

supplement the' 1990 HMDA data. 

Theirsample consisted of 3,062 appli 

cations for residential mortgage loans 

that were either approved or denied, 

including 722 minority applications 

and 2,340 white applications. Infor 

mation was requested for 38 addi 

tional factors that mortgage 

underwriters and lenders indicated 

were important in evaluating appli 

cant ereditworthiness, including: net 

worth, liquid assets, total assets, liabil 

ities, proposed housing expenses, 

total proposed obligations, credit his 

tory, purchase price, loan amount and 

appraised value. Data were collected 

on the age, years of schooling, marital 

status, number of dependents, and 

years employed in the line of work 

and in the current job for both appli 

cants and co-applicants. Detailed in 

formation on job position and cype of 

business was requested. The survey 

also addressed loan characteristics, in 

cluding whether the loan was fixed or 

adjustable, the loan term, type of 

property to be financed, whether pri 

vate mortgage insurance was sought 

and approved, whether a gift or grant 

was included in the down payment, 

whether the loan was co-signed by 

someone other than the applicants, 

and whether information could not be 

verified. The property location data 

were used to obtain information about 

characteristics of the neighborhoods 

such as the ratio of rents to the value 

of rental housing stock. Of these, 13 

variables were included in the final 

model.7 

The Boston Fed data confirmed 

that differences between minority 

and white applicants existed over a 

wide range of variables. White appli 

cants had higher incomes, higher net 

worth, and better credit histories. 

White applicants also had lower 

loan/appraisal ratios, were less likely 

to apply for private mortgage insur 

ance, were less likely to purchase 

multifamily homes, were more likely 

to be married, and were less likely to 

have dependents.8 On the other 

hand, minority applicants appeared to 

have housing expenses and debt obli 

gations relative to income that were 

similar to those observed for white 

applicants. The lending disparities in 

the aggregate HMDA data were rep 

licated in the Boston Fed sample. Ex 

cluding withdrawn applications, 28.1 

percent of minority applicants were 

denied mortgage loans versus 10.3 per 

cent of white applicants.9 

The effect of minority status, 

which encompassed both black and 

Hispanic applicants, was estimated in 

a multivariate regression framework 

to measure the impact of race, holding 

other factors constant.10 The model 

estimates were generated using a logit 

regression approach, measuring the 

impact of race through the use of a 

dummy variable. The impact of race 

was found to be statistically signifi 

cant, although the inclusion of the 

other variables in the model reduced 

the size of the effect of minority status 

by about half relative to the effect 

indicated by the unadjusted rejection 

rates. The study concluded that 

"race does play a role as lenders con 

sider whether to deny or approve 

mortgage loan applications ... A 

black or Hispanic applicant in the 

Boston area is roughly 60 percent 

more likely to be denied a mortgage 

loan than a similarly situated white 

applicant. This means that 17 per 

cent of black or Hispanic applicants 

instead of 11 percent would be denied 

loans, even if they had the same obli 

gation ratios, credit histories, loan tc 

value, and property characteristics as 

white applicants."11 

The race effect reflects the differ 

ence in denial rates between white 

and minority applicants not captured 

by the other variables in the model. 

To the extent that the model is cor 

rectly specified and includes all rele 

vant variables, this race differential 

may be attributable to discrimination 

because the model would indicate 

disparate treatment of minority indi 

viduals, controlling for other attri 

butes. The authors of the Boston Fed 

study argue that all important factors 

considered by loan underwriters were 

considered in constructing the model, 

the race coefficient is stable with re 

spect to different model specifica 

tions, the model fits the data well, and 

the race effect persists when under 

writing standards or size of the insti 

tution are held constant. 

Results ofFile Reviews 

The Boston Fed study produced 

results that appear to be inconsistent 

with the findings of previous compli 

ance examinations. Prompted by the 

conclusions of the study, FDIC staff 

examined the loan files at FDIC-su

pervised institutions included in rhe 

Boston Fed study in order to identify 

instances of discriminatory lending 

behavior. In addition, the reviews 

provided an opportunity to obtain in 

formation to evaluate the statistical 

model. The examiners were asked to 

check the accuracy of the data used in 

the study, to search for factors that 

were important in the loan-decision 

process that were not captured by the 

model, and to determine whether the 

data were interpreted consistently 

and appropriately. 

The examiners had access to the 

loan files at those institutions for 

Munnell eta/., p. 4. 

The factors included in the model are pro 

vided in Table 2, with model coefficients and 

t-statistics. All the factors are statistically signif 

icant, with the exception of net wealth. 

sMunncll«/«/., Table 4, p. 24. 

'Munnell et a/.. Table 2, p. 21. 

Under HMDA reporting requirements, 

"Hispanic" is characterized as a racial category. 

"Munnell eta!,, pp. 43-44, 
FDIC Banking Review 

which the FDIC was the primary fed 

eral bank regulator. Of the 131 insti 

tutions participating in the Boston 

Fed survey, the 70 FDIC-supervised 

institutions accounted for 45 percent 

of the mortgage applications in the 

Boston Fed sample. The FDIC, 

which has responsibility for enforcing 

regulations that prohibit discrimina 

tion at these institutions, evaluated 

lending patterns at these institutions 

using the Boston Fed data. Of these 

70 institutions, 23 lenders reported no 

minority applicants; 24 lenders re 

ported minority applications but no 

rejections of minority applicants. 

These 47 lenders were excluded from 

further consideration for the purpose 

of the file reviews because the lend 

ing bias results in the Boston Fed 

study are based on rejections of mi 

nority applicants. 

The denial probabilities generated 

by the statistical model were used to 

identify loan files for scrutiny by bank 

examiners. The Boston Fed pro 

vided the FDIC with a report listing 

denial probabilities for those rejected 

loan applications where the probabil 

ity of denial produced by the statisti 

cal model was 50 percent or less, after 

omitting the race variable from the 

model. This list, which was referred 

to as the exception list, was intended 

to highlight applicants who were de 

nied despite appearing to be rela 

tively more qualified. Of the 23 

institutions of interest, four institu 

tions did not have any rejected minor 

ity applications that appeared on the 

exception list. Examiners reviewed 

every application on the exception list 

(minority and white) at the remaining 

19 institutions, with the exception of 

seven files that had been destroyed or 

could not be located. A total of 95 

applicant files listed in the exception 

report were reviewed, of which 62 cor 

responded to minority applicants and 

33 to white applicants. For compari 

son purposes, it may be useful to note 

that 99 of 293 minority applicants 

(33.8 percent) were rejected at all 70 

FDIC-supervised institutions versus 

106 of the 1,100 white applicants (9.6 

percent). 

The next step was to identify for 

further review those institutions with 

approved loan files comparable to the 

denied applications on the Boston 

Fed exception list. Such files were 

identified at five of the 19 institutions 

in which the excepted files had been 

reviewed. Where few approved files 

could be located, examiners reviewed 

more-recent loan application files that 

were not in the original sample.13 

The author selected a small num 

ber of additional loan files for review 

where applicants had been approved 

despite obvious weaknesses such as 

high obligation ratios, poor credit his 

tories, and inadequate liquid assets 

and net worth, according to the Bos 

ton Fed data. These selection criteria 

were used, in part, because (1) one 

indication of lending bias is whether 

white applicants with relatively weak 

applications are approved, and (2) 

model probabilities did not appear to 

reflect the red it worthiness of the ap 

plicants when file reviews were con 

ducted. These reviews could be 

useful to determine whether the loan 

approvals represented exceptions to 

underwriting standards or were based 

on important factors that had been 

omitted from the statistical model. 

The process of reviewing the files 

and comparing the strength of the ap 

plications to the probabilities gener 

ated by the Boston Fed model 

demonstrated that the probabilities 

did not reflect the extent of problems 

that appeared in the files in many 

cases. Serious weaknesses often ex 

isted for applications whose denial 

probabilities were quite low. The file 

reviews indicated the importance of 

numerous problems that could influ 

ence the estimated coefficients in the 

model, These data problems are 

summarized in Table 1. 

The errors summarized in Table 1 

refer only to those rejected applica 

tions on the exception list that were 

reviewed by examiners. Although 

many of the loan files revealed multi 

ple problems, each of the 95 loan files 

is categorized according to the de 

scription that appears most appropri 

ate from the perspective of the model 

specification to avoid double count 

ing. The first three error cypes refer 

to problems with the loan outcome 

variable. Of the 95 loan files re 

viewed, five had been approved, eight 

had been withdrawn and six appli 

cants received counteroffers. Five 

applications were rejected from spe 

cial affordable housing programs be 

cause they were overqualified. One 

application was rejected after the 

lender was informed that the VA 

would not approve the loan. Another 

application was rejected after the 

lender was unable to obtain PMI ap 

proval (the PMI variable was incor 

rectly coded in the Boston Fed data). 

Examiners noted data problems in 28 

of the remaining applications that 

would be sufficiently serious to influ 

ence the denial probability generated 

by the model. Overall, 57 percent of 

the applicant files contained serious 

data errors, including those where 

critical information could not be veri

fed. Examiners carefully inspected 

the values of variables that related to 

the reasons for denial, but generally 

did not scrutinize all the data ele 

ments for each file. As a result, Table 

1 may underestimate the magnitude 

of the serious data problems. 

The following discussion exam 

ines the implications of these data 

problems in terms of the following 

categories: (1) data errors, (2) specifi 

cation of the dependent variables, (3) 

Institutions are required to keep the de 

nied loan applications for 25 months. Because 

examiners reviewed the 1990 applications in 

1993, it was surprising thai such a large propor 

tion of the files was still available. 

Many of the approved files could nor. be 

located because a large proportion of mortgages 

originated in 1990 has since been refinanced. 
Mortgage-Lend ing Bias 

measurement of applicants' financial 

resources, and (4) other model speci 

fication problems. 

Data Errors 

The Boston Fed data, including 

the variables incorporated in the sta 

tistical model, appear to suffer from a 

substantial amount of reporting error. 

Errors associated with the variables in 

the statistical model alone were noted 

by examiners in 57 percent of the loan 

files on the exception list, although 

there was substantial variation in the 

extent of these errors. Many coding 

errors appeared to be random. The 

quality of the data varied across insti 

tutions as well; the data reported by 

some institutions were so poor that 

the estimated denial probabilities did 

not provide useful information re 

garding the characteristics of the ac 

tual loan applications. Confusion 

regarding the units of measurement 

that were to be reported may have 

contributed to some data problems, 

particularly where institutions were 

required to report numbers in thou 

sands or to convert months to years. 

For example, one couple who applied 

for a mortgage were legal aliens who 

had been in the country for one year 

and had two months' work experience 

in the United States, although the 

Boston Fed data indicated a two-year 

work history. 

Several examiners reported that 

the Boston Fed data appeared to re 

flect the data listed on the original 

application rather than the final, veri 

fied data upon which lending deci 

sions were based. The final data 

considered by lenders can differ sig 

nificantly from data reported in the 

original application, depending upon 

how lenders treat different sources of 

income and whether assets, income, 

employment or other information are 

verified. Examiners found applica 

tions where applicant debt was under

reported, income figures were 

inaccurate, assets could not be veri 

fied, or other information became 

available during processing that influ 

enced the primary ratios or other fac 

tors. In addition, when lenders 

uncover deficiencies with the applica 

tion that are sufficient to warrant a 

denial, other factors may never be ver 

ified because processing is termi 

nated. In contrast, all relevant 

information normally will be verified 

for applications that are approved. 

For these reasons, the creditworthi

ness of rejected applications is likely 

to be systematically overstated rela 

tive to approved applications. 

Interpretation of the 

Dependent Variable 

The reviews revealed that the clas 

sification of an application as "de 

nied" was incorrect or questionable in 

certain circumstances. Five applica 

tions that were coded as rejections 

had actually been approved by lend 

ers. Of these, three mortgages were 

originated as a result of applicants ac 

cepting counteroffers and anotherap

plication was withdrawn subsequent 

to the loan approval. The remaining 

loan was never originated due to seri 

ous property title problems, although 

the loan had been approved and a 

commitment letter was issued by the 

lender before the title problems arose. 

Proper classification of this applica 

tion is somewhat ambiguous because 

the decision to finance the mortgage 

was rescinded. The loan approval 

and letter of commitment could be 

considered to indicate clearly that the 

lender was willing to provide funds 

based on the applicant characteristics. 

However, the actual coding (as a de 

nial) is consistent with HMDA report 

ing requirements. 

Although the Boston Fed intended 

to delete withdrawals, the reviews 

showed that eight applications on the 

exception list (coded as denials) had 

actually been withdrawn. Withdraw 

als were caused by a variety of factors. 

In one case, the application was really 

a pre-application. No fee or deposit 

was paid, and the applicants subse 

quently informed the institution that 

they had decided not to purchase the 

property. Another application was 

unsigned and incomplete, and the ap 

plicant did not respond to requests for 

additional information. A third appli 

cation was never completed because 

the buyer and seller could not agree 

on sale terms. Four applications were 

withdrawn after institutions re 

quested additional documentation to 

verify financial information. A num 

ber of these applications could be re 

garded as incomplete, but the 

distinction between an incomplete 

and a withdrawn application is ambig 

uous. In each case the decision not to 

proceed was made by the applicants. 

Another instance of a loan outcome 

that could be considered to be a with 

drawal involved an applicant who had 

previously been rejected by one insti 

tution and who subsequently submit 

ted an incomplete application to a 

second institution. The application 

at the second institution was rejected 

because additional documentation 

was not provided by the applicant. 

This application appeared to have 

been motivated by the applicant's de 

sire to recover the deposit. Two re 

jections may be considered sufficient 

evidence that a potential buyer can 

not obtain financing, in which case 

the individual is entitled to a refund 

of the deposit. This hypothesis is 

supported by the observation that the 

second institution later approved a 

mortgage loan on another property for 

this same applicant based on a com 

plete application. 

The designation of loan outcomes 

as lender decisions may be inappro 

priate when counteroffers are in 

volved. When a lender rejects the 

original loan application but subse 

quently extends a counteroffer, the 

loan outcome is characterized as an 

approval if the applicant accepts the 

loan. If the counteroffer is refused, 

the outcome is characterized as a 

lender rejection. Onerous counterof 

fers can be used to discriminate 

against minority applicants. In such 

cases it is appropriate to treat rejected 

counteroffers as lender rejections. 

For reasonable counteroffers, in con 

trast, the final loan outcome is the 

result of a series of decisions by both 

applicants and lenders. It is not obvi 

ous how counteroffers should be 

treated in a model intended to explain 

lender behavior, because the terms of 

counteroffers cannot be evaluated 

without a considerable amount of de 

tailed information. The classifica 

tion of such counteroffers as lender 
FDIC Banking Review 

rejections may be inconsistent with 

how the model results have been in 

terpreted, i.e., (1) rejections represent 

lender decisions and (2) rejections 

deny individuals an opportunity to 

own a home. The loan outcomes 

were characterized as denials in each 

of these instances when applicants re 

jected these offers. Single-equation 

estimation may be an inappropriate 

procedure to identify the effect of 

race in these circumstances.14 

Six of the excepted files could be 

characterized as counteroffers (ex 

cluding those counteroffers coded as 

denials that actually were accepted as 

described above). Counteroffers that 

are accepted would be reported as ap 

provals under HMDA. Counteroffers 

were made for a variety of reasons. In 

one case an individual applied for a 

fixed-rate loan with no points. The 

applicant was informed that the 

lender did not offer this product and 

was offered an available zero-point 

adjustable-rate mortgage (ARM). In 

one instance when a condominium 

unit was too small to meet secondary 

market standards the lender offered 

ARM financing. ARMs mitigate 

lenders' interest-rate risk when lend 

ers intend to hold the mortgages in 

their own portfolio. separate appli 

cation that involved a property that 

had been illegally converted to three 

units was approved, conditional on 

conversion to a two-unit property. 

Two individuals submitting applica 

tions regarded as marginal were in 

formed that the lender would finance 

the mortgage loan if the loan amount 

were reduced to 90 percent from 95 

percent. One lender offered to work 

with an applicant to reevaluate their 

credit history. In each of these cases 

the applicants did not accept the 

counteroffers. 

A number of individuals who ap 

plied to participate in special afford 

able housing programs were ruled to 

be ineligible because they exceeded 

specified program limits for income, 

assets, or other criteria. Of the 95 files 

reviewed, five applicants (all minority 

applicants) were rejected because 

they were overqualified for these pro 

grams (although a high obligation 

ratio was also cited as a problem in one 

instance). It is precisely because 

these applicants would be expected to 

qualify for conventional mortgages 

that they are rejected from these spe 

cial programs. The counting of these 

applications as lender rejections exag 

gerates minority denial rates because 

(1) several of the applicants were bet 

ter qualified in many respects than 

the average white or minority appli 

cants who were approved (with 

monthly incomes as high as $7,000), 

and (2) minority applicants in the Bos 

ton Fed sample were more likely to 

apply for mortgages through these 

special programs.15 

Lenders who also plan to sell their 

mortgages in the secondary market 

tend to evaluate mortgage applica 

tions on the basis of underwriting 

guidelines of the intended purchaser, 

such as Fannie Mae or Freddie Mac. 

However, the file reviews docu 

mented one instance where a lender 

apparently was willing to provide loan 

financing for a Veterans Administra 

tion (VA) mortgage, but the applica 

tion was rejected by the VA after the 

documentation had been submitted 

by the lender. The application was 

reported as a denial, consistent with 

HMDA guidelines, but the interpre 

tation of this as a lender denial is ques 

tionable. If a lender demonstrates a 

willingness to originate a loan but the 

purchaser subsequently overrides the 

approval, it is not accurate to charac 

terize this decision as a lender denial. 

Similarly, it would seem inappropri 

ate to interpret a race effect resulting 

from such outcomes as the result of 

discrimination by lenders. This issue 

is central to the debate over the role 

of race. It is precisely because 

lenders' decisions to originate mort 

gages for resale in the secondary mar 

ket cannot be distinguished from 

whether applicants qualify according 

to the underwriting criteria imposed 

by the secondary market participants 

that the statistical model is used to 

attempt to control for the impact of 

such factors. 

As discussed by the authors, pri 

vate mortgage insurance (PMI) pres 

ents an additional model estimation 

problem. Applications typically are 

not submitted for PMI unless a lender 

intends to approve the loan applica 

tion. To the extent that the PMI re 

jection does not reflect lender 

behavior, it is incorrect to interpret a 

loan rejected for PMI as a lender de 

nial. For lenders that require PMI for 

all mortgages, it may be appropriate to 

exclude PMI rejections from the 

model estimation. However, proper 

treatment of PMI rejections is compli 

cated by the fact that lenders could 

choose to forego PMI requirements 

for mortgages that they intend to hold 

in their own portfolio. Lenders could 

discriminate against marginal appli 

cants by selectively requiring PMI on 

the basis of an applicant's race. This 

effect would not be captured by either 

including PMI as an explanatory vari 

able in the model or by excluding 

PMI rejections altogether. Examin 

ers could investigate this potential 

source of disparate treatment by scru 

tinizing whether a lender exempts ap 

plicants from standard PMI 

requirements and the process by 

which such applicants are selected. 

14G.S. Maddala and Robert P. Trost (1982) 

show how model estimates vary when supply 

and demand equations are specified separately. 

Others, including Galster (1991) and Yinger 

(1993), discuss problems interpreting estimates 

from single-equation models of mortgage lend 

ing discrimination when outcomes reflect deci 

sions by both applicants and lenders. Perle, 

Lynch and Horner (1993) demonstrate chat re 

duced-form estimates of the race effect using 

HMDA data are sensitive to model specifica 

tion. One way that the model could be modified 

to reflect counteroffers is to classify counterof 

fers as separate loan outcome categories and use 

a multinomial logic regression co estimate the 

model, e.g., Schafer and Ladd (1981). This ap 

proach may not capture the complex nature of 

counteroffers, although rejections and approv 

als would be more appropriately defined. How 

ever, counteroffers are not reported separately 

under HMDA. 

Munnell el a/, estimate chat between 12 

and 16 percent of whites (depending upon loan 

outcome), versus about 40 percent of minority 

applicants, applied through special loan pro 

grams (Munnell eta/., Table 4, p. 24). Examina 

tion of this category revealed such programs as 

Jumbo Mortgages and 15-Year Mortgages, sale 

of real estate held by the bank, and other cate 

gories hardly consistenc with affordable housing 

or first-time homebuyer programs. After elimi 

nating programs chat could noc be identified as 

affordable housing and firsc-time homebuyer 

programs, participation in special programs ap 

pears much lower. Between six and seven per 

cent of whites, versus 31 to 34 percent of 

minority applicants, applied for mortgage loans 

through these special programs. 
Mortgage-Lending Bias 

This selection issue would not be rel 

evant for the many institutions that 

sell all of their mortgages to the sec 

ondary market. 

The Boston Fed compared several 

models with alternative treatment of 

the PMI variable. Exclusion of the 

observations for which PMI was de 

nied (and for which the PMI rejection 

was correctly coded) had no effect on 

the magnitude or significance of the 

race effect, according to the Boston 

Fed report. Applications with PMI 

rejections would not be expected to 

appear on the exception list: the 

probability of denial exceeds 0.5 

when PMI is denied because> as the 

authors note, "the denial of private 

mortgage insurance virtually pre 

cludes attaining a mortgage."16 How 

ever, one application with a PMI 

rejection incorrectly coded was found 

during the file reviews. 

Several cases involved what might 

be considered rejections with special 

considerations. For example, one re 

jection was reversed by an institution 

one week after review of the initial 

decision, but the applicant already 

had obtained alternative financing. 

The applicant declined the offer. 

Without additional information about 

the particular circumstances, it is dif 

ficult to determine whether the sub 

sequent decision to provide financing 

was made in good faith. Given the 

amount of time that had elapsed be 

fore the decision was reversed, the 

denial may well be the appropriate 

characterization of the loan outcome. 

The impact of the factors dis 

cussed above on the model results is 

likely to be significant. Of the 62 mi 

nority applications reviewed by ex 

aminers, three were approved, six 

refused counteroffers, six were with 

drawn, five were rejected because 

they were overqualified for special 

housing programs, one was approved 

by the lender but was turned down by 

the intended purchaser, and one was 

rejected on the basis of PMI. In all, 

22 of the 62 minority applications on 

the exception list (35 percent) repre 

sent instances whereby the loan out 

come variable is either incorrect or 

may not reflect the decision of the 

lender. Another ten (16 percent) 

were found to contain errors that 

would influence the parameter esti 

mates of the model. The quality of 

the data for white applicants also ex 

hibited problems. However, only 

four of the 33 white applicants (12 

percent) represented instances 

whereby the loan denial was found to 

be interpreted either incorrectly or 

ambiguously. 

Given the purpose and interpreta 

tion of the model, the loan outcome 

variable (accept versus reject) should 

be specified to reflect lender deci 

sions. If denials result from decisions 

made by applicants (in the case of 

some counteroffers), mortgage insur 

ance companies (when PMI is re 

jected), or parties other than the 

mortgage lender, it is inappropriate to 

conclude that higher minority rejec 

tion rates necessarily reflect racial dis

crimination by lenders. It is 

inappropriate to interpret PMI rejec 

tions as lender denials if the lender 

does not influence this decision. The 

appropriate treatment of withdrawals 

is less clear because withdrawals may 

occur as a result of actions by either 

applicants or lenders. Applicants re 

jected from special loan programs be 

cause they are overqualified should 

be excluded from the model because 

these applicants may be qualified for 

conventional mortgages and the de 

nial does not imply that lenders are 

unwilling to provide a loan. Reason 

able counteroffers might be counted 

as approvals regardless of whether the 

loan is originated because (1) appli 

cants have an opportunity to accept or 

reject the offer, and (2) accepted 

counteroffers currently are reported 

as approvals. Unfortunately, it is dif 

ficult to determine whether a coun 

teroffer is reasonable. Nevertheless, 

to the extent some counteroffers are 

reasonable, an approach that classifies 

all rejected counteroffers as lender 

denials is likely to exaggerate the race 

effect to the extent that minorities 

receive a disproporttonate number of 

counteroffers. 

Measurement ofApplicants' 

Financial Resources 

Neither net worth nor liquid assets 

were found to have a statistically sig 

nificant influence on loan outcome in 

the model. The authors suggest that 

the effect of liquid assets may be cap 

tured by the loan-to-value ratio. 

There are a number of other possible 

explanations, however, for the finding 

that liquid assets were statistically in 

significant. A number of factors per 

taining to the measurement of 

applicants' financial resources were 

either omitted from the final model or 

suffered from measurement prob 

lems. In particular, the liquid asset 

measure does not reflect other poten 

tial sources of funds. In addition, 

lenders provided information on re 

ported rather than verified assets in 

some cases, and the applicants' finan 

cial resources were measured in abso 

lute terms rather than relative to 

closing costs. These and other prob 

lems discussed below may have con 

tributed to the model results that 

liquid assets had no statistically signif 

icant impact on the probability of de 

nial. 

As acknowledged by the authors, it 

is puzzling that liquid assets did not 

appear statistically significant. Un 

derwriting guidelines generally re 

quire that borrowers have sufficient 

funds at closing to cover the down 

payment, closing costs, and prepaid 

items.17 Typical sources include: de 

posit on sales contract, checking and 

savings accounts, gifts or grants, pro 

ceeds from sale (or anticipated sale) of 

currently owned home, bridge loans, 

net withdrawal from IRA/Keogh ac 

counts, securities, and trust ac 

counts.18 These sources of funds 

include both liquid assets as reported 

on application forms (typically cash 

and savings) as well as assets that are 

potential sources of cash because they 

/., p. 31. 

Prepaid settlement costs specified by 

Fannie Mae include: "interest charges covering 

any period after the settlement date; real-estate 

taxes covering any period after the settlement 

date; hazard insurance premiums; and the es 

crow accruals required for renewal of the mort 

gage insurance premium (unless the premium 

is being financed as part of the mortgage 

amount)." Fannie Mae Selling Guide (Part VI: 

Underwriting Guidelines), p. 637. 

See, for example, "Sources of Borrower's 

Funds," Fannie Mae Selling Guide (Part VI: Un 

derwriting Guidelines), pp. 640-44. 
FDIC Banking Review 

may be liquidated before the closing. 

In addition, gifts that have been 

pledged but not yet received are not 

included in applicants' assets. The 

file reviews appeared to confirm that 

the inability to supply sufficient funds 

at closing was a factor considered im 

portant by lenders; in 26 of the 95 

rejected applications reviewed, appli 

cants did not have sufficient funds. In 

some cases the lack of funds was ex 

treme. For example, in one case the 

applicants did not have sufficient 

funds to pay for the appraisal, let alone 

the down payment and other closing 

costs. Verification was also a problem. 

Of the 26 applications with problems 

relating to funds, 13 applications re 

ported assets that could not be veri 

fied. The importance of sufficient 

funds is consistent with other research 

on potential homebuyers. Apgar eta/. 

(1990) note that, for the 11 million 

households headed by individuals 

aged 25 to 34, "upfront cash cost is 

clearly the more difficult hurdle for 

these young prospective homebuyers: 

81 percent did not have the accumu 

lated wealth to make the down pay 

ment."19 

The review of approved files dem 

onstrated the importance of home eq 

uity for applicants who currently own 

property. There is no variable that 

directly indicates whether the appli 

cant is a first-time homebuyer or a 

current owner, although homeowner 

status may be inferred from the mort 

gage credit variable. No variable re 

flects the amount of home equity 

available to applicants. Equity is in 

cluded in total net worth estimates, 

but net worth includes items such as 

personal property, automobiles, home 

furnishings, and other assets that are 

difficult to verify and that are not typ 

ically liquidated to provide cash at 

closing. Indeed, as reported by the 

authors, lenders generally indicate 

that they do not place much weight on 

net worth in making mortgage lend 

ing decisions. 

Approximately 17 percent of the 

applications reported by FDIG insti 

tutions relied on gifts or grants to fi 

nance part of the down payment. A 

review of a number of files corre 

sponding to applications that were ap 

proved despite apparent financial 

weaknesses revealed that some firsttime homebuyers relied upon finan 

cial gifts from relatives to finance 

down payments and closing costs. 

These gifts ranged from several thou 

sands of dollars to as much as $68,000. 

The importance of gifts in this sample 

is consistent with survey research that 

indicates that 28 percent of first-time 

owners rely on gifts from parents,20 

Although the Boston Fed data include 

a dummy variable to indicate whether 

the applicant is relying on a gift, there 

is no information on the magnitude of 

the gift. Moreover, the variable indi 

cating reliance on a gift was not always 

reliable. Examiners noted in three of 

the rejected applications reviewed 

that gifts could not be verified or were 

not forthcoming. 

To some extent, gifts may be used 

by applicants to reduce their loan-to

value ratio, a variable that is included 

in the model. However, some appli 

cants — particularly first-time 

homebuyers may depend on gifts 

just to meet minimum financing re 

quirements. For these borrowers, a 

gift may make the difference between 

not getting a loan at all versus getting 

a loan at the maximum allowable loan

to-value ratio. 

The omission of gifts and home 

equity from the statistical model 

could bias the estimated race effect by 

underestimating the financial re 

sources of white applicants relative to 

minority applicants. The limited in 

formation on gifts in the model may 

bias the race estimates if white firsttime homebuyers have access to 

larger gifts than do minority appli 

cants because of existing disparities in 

wealth between white and minority 

households. Similarly, because 

homeownership rates are higher 

among whites, white applicants are 

more likely to rely on home equity to 

qualify for a new mortgage. Survey 

data show that "whites were twice as 

likely as blacks to use equity from a 

previously owned home."21 

The measurement of applicants1 

financial resources may also be sub 

ject to a certain amount of systematic 

error. In particular, lenders some 

times provided reported rather than 

verified assets. When applications are 

rejected on other grounds, lenders 

have no reason to continue to process 

the application and to verify assets 

that have not already been confirmed. 

Such errors would tend to systemati 

cally overestimate the assets of de 

nied applicants. 

Finally, lenders do not require a 

fixed dollar amount of assets. Rather, 

potentially-liquid assets are com 

pared to the down payment and clos 

ing cosrs to determine whether the 

applicant has sufficient funds to fi 

nance the purchase of the property 

and to meet several months of mort 

gage payments and other prepaid 

costs. Future research in this area 

might include modelling assets as a 

dummy variable to indicate whether 

sufficient assets were available to 

meet the financing requirements, 

or as a ratio of available funds to fi 

nancing requirements, rather than as 

a continuous variable reflecting total 

assets. 

Other Specification Problems 

Many other types of problems 

found in the file reviews are difficult 

to characterize in summary fashion, 

let alone capture in a statistical model. 

For example, several applicants lost 

their jobs after the applications were 

submitted. The reviews documented 

one instance where a co-applicant 

who had recently immigrated to the 

U.S. had not obtained a work permit. 

One applicant relied on a co-signer 

who had been sued for damages that 

exceeded the co-signer's net worth. 

Each of these instances represented 

good credit risks according to the sta 

tistical model; each application was 

assigned a low probability of denial. 

The file reviews indicated that 

property characteristics were a poten 

tially important factor omitted from 

the Boston Fed model. A number of 

applications were rejected because of 

problems with the property. Three 

Apgarara/., p. 16. 

National Association of Realtors (1992). 

21 Ibid., p. 27. 
Mortgage-Lending Bias 

condominiums were rejected by lend 

ers because the units were in build 

ings with low rates of owner-occupancy. 

As a result, the mortgages would not 

meet secondary market require 

ments. Secondary market standards 

were particularly important in these 

instances because each of the lenders 

sold all originated mortgages in the 

secondary market. One application 

involved a special 99-year lease pro 

gram and the collateral value in case 

of foreclosure was questionable. Sev 

eral properties were uninhabitable or 

required substantial renovations. 

Even when the appraised value ex 

ceeds the loan amount, in these 

circumstances lenders require that 

applicants have sufficient experience 

and resources to ensure that the reno 

vations will be completed. In one 

case an applicant applied for a 30-year 

mortgage to finance a property that 

was determined to have a useful life 

of 20 years. 

Credit history was a common prob 

lem among rejected applicants. Al 

most half of the rejected applications 

that were reviewed suffered from 

serious credit problems such as 

charge-offs, defaults, collections, re 

possessions, tax judgments, and mul 

tiple accounts overdue at least 60 

days. Serious credit problems may be 

considered sufficient grounds to re 

ject a mortgage application because 

these problems may indicate an un 

willingness or inability of the appli 

cant to meet debt obligations. 

However, the model results imply 

that applications with serious credit 

problems were likely to be approved, 

Applications with serious credit prob 

lems that were accompanied by a 

public record of default, foreclosure, 

or bankruptcy were less likely to be 

approved because a public record, ac 

cording to the Boston Fed, "is consid 

ered especially damaging to the 

borrower."22 One potential explana 

tion for this relatively small credit his 

tory effect is that the consumer credit 

and mortgage credit variables ap 

peared to be poor measures of the 

severity of credit problems from the 

perspective of loan underwriters. In 

addition, the linear specification of 

the model has limited intuitive ap 

peal, and the mortgage credit variable 

may reflect homeownership status. It 

should be noted, however, that the 

linear specification did not appear to 

influence the results: alternative 

specifications had little impact on 

other coefficients in the Boston Fed 

model. 

Some distinctions that appeared to 

be important to underwriters were not 

captured by the credit variables in the 

model. Lenders had institutional 

knowledge that was used in evaluat 

ing the seriousness of credit reports. 

For example, late-payment reports 

from several firms were discounted 

because the companies are notorious 

for reporting errors. In addition, if an 

applicant's credit report revealed evi 

dence of past problems that had since 

been resolved, reasonable explana 

tions were generally considered suffi 

cient. Such one-time events as 

financial difficulties due to medical 

expenses, finishing college or gradu 

ate school, or family problems gener 

ally were not considered obstacles to 

obtaining a mortgage if the debts had 

been settled. Although the variable 

in the model does not distinguish be 

tween one-time credit problems re 

solved in the past and similar credit 

problems that are persistent and 

involve current accounts, lenders 

appeared to treat these cases differ 

ently.23 

Munnell eta/, suggest that minor 

ity applicants tend to be rejected 

when credit history is marginal, in part 

because such applicants are not pro 

vided assistance or credit counseling, 

or that white applicants tend to be 

given the benefit of the doubt when 

credit problems arise.24 To the extent 

that lenders engage in such behavior, 

evidence of this phenomenon should 

be evident in this sample of applica 

tions because the exception list 

should represent the most creditwor 

thy of rejected applicants. The file 

reviews did not support this thesis. 

Those applicants rejected on the 

basis of credit problems generally had 

extremely serious credit problems as 

well as other negative factors, with 

few if any compensating factors. 

There was not a single instance where 

a few late payments, several creditcard delinquencies, or other minor 

credit problems appeared to raise con 

cerns to the lenders or generated an 

adverse Loan outcome. Most of the 

applications rejected on the basis of 

poor credit also suffered from other 

types of problems such as excessive 

obligations or housing expenses rela 

tive to income, or insufficient assets. 

To accommodate differences in 

applicant circumstances, underwrit 

ing guidelines are not interpreted as 

strict limits. For example, lenders 

specify standards for the housing ex 

pense and total obligation ratios, but 

these standards may be exceeded if 

other "compensating factors" indi 

cate an applicant's ability or willing 

ness to meet mortgage payments, or 

Munnell «■«/., p.I5. 

Fannie Mae guidelines, for example, spe 

cifically require chat: "Any judgments, garnish 

ments, or liens must be paid in full before 

closing ... A bankruptcy must have been 

discharged Fully and the borrower musi have 

re-established good credit and demonstrated an 

ability to manage financial affairs ... Gener 

ally, we will not purchase or securitize a mort 

gage if the borrowers) has been a defendant in 

mortgage foreclosure proceedings that were 

completed in the past three years. However, if 

the foreclosure was the result of extenuating 

circumstances beyond che control of an owneroccupant borrower such as a serious, long

term illness; death of the principal wage-earner; 

or loss of employment because of factory slow 

downs or shutdown, reducrions-in-force, etc. — 

we will purchase or securitize the mortgage as 

long as the lender's underwriting confirms that 

the borrower has re-escablished good credit and 

has demonstrated an ability to manage financial 

affairs." Fannie Mae Selling Guide (Part VI: Un 

derwriting Guidelines), pp. 650-51. 

One explanation for the observed dispar 

ities in mortgage lending is that white appli 

cants receive more coaching than minority 

applicants, referred to as the "thicker file" phe 

nomenon. Loan officers might provide more 

assistance to white applicants by requesting 

more documentation for weaknesses in the ap 

plication (such as credit problems) or rearrang 

ing finances (such as paying off certain debts) 

Co meet primary underwriting criteria. As a re 

sult, white applicants would appear to be more 

qualified than similar minority applicants when 

evaluated on the basis of information in che loan 

file, regardless ofwhether the applications were 

analyzed by examiners or by the use of a statis 

tical model. Examiners were asked specifically 

to inspect the loan files for evidence of addi 

tional assistance or coaching that may have 

been furnished to whice applicants, but found 

no evidence that whites were provided with 

more assiscance than minority applicants. 
FDIC Banking Review 

if lenders obtain more protection 

against potential loss. The role of 

compensating factors is explicitly rec 

ognized by Fannie Mae underwriting 

guidelines and are consistent with 

guidelines used by many lenders.25 

Munnell etal. note that underwrit 

ing benchmarks may be exceeded 

when compensating factors are docu 

mented.26 The importance of com 

pensating factors was evident in the 

file reviews when "comparable" files 

were identified at an institution, par 

ticularly when a rejected application 

was compared to an approved applica 

tion with similar characteristics. Ap 

plications with above-normal 

obligation ratios were approved, for 

example, if applicants held relatively 

high levels of equity in the property 

(which minimizes the potential expo 

sure of the lender, in addition to in 

creasing the incentive for the owner 

to avoid defaulting on the property). 

This example illustrates that lenders 

may not consider some of these com 

pensating factors unless other vari 

ables (such as obligation ratios) 

exceed standards but are below upper 

limits that would automatically dis 

qualify the applications. It is difficult 

to model the effects of compensating 

factors because the underwriting 

guidelines imply complex interac 

tions among numerous factors where 

the relative importance of one vari 

able depends upon the value of other 

variables and whether these values 

exceed specific thresholds. The Bos 

ton Fed model is not specified to re 

flect these interactions; this may be a 

fruitful area for future research. 

The file reviews demonstrated 

many of the problems with the Boston 

Fed data. In theory, it would be pos 

sible to reestimate the race effect 

using the FDIC sample after correct 

ing for many of the data errors dis 

cussed above. Although this effort 

might be useful to demonstrate the 

sensitivity of the parameterestimates, 

the resulting estimate of the race ef 

fect could not be considered an accu 

rate measure of potential lending 

discrimination for several reasons. 

First, information is not available for 

a number of omitted variables. For 

example, the degree to which ap 

proved applicants relied upon gifts 

cannot be determined because only a 

small sample ofapproved applications 

was examined. Similarly, corrected 

information is unavailable for those 

items not verified when application 

processing was discontinued because 

the application was rejected on the 

basis of other data. Second, the file 

reviews conducted by examiners in 

cluded only rejected applications, for 

which minorities are over-repre 

sented, but excluded approved appli 

cations, for which whites are 

over-represented. To correct for just 

those applications that appeared on 

the exception list, therefore, could it 

self induce a race effect, 

Model Fit 

number of potential measures of 

goodness of fit have been proposed 

for models with discrete dependent 

variables (known as qualitative re 

sponse models). The dependent vari 

able in the Boston Fed model, loan 

outcome, takes only two values (1 or 

0) corresponding to denied or ap 

proved, but the predicted values gen 

erated by the model reflect the 

probability of denial. As a result, the 

R2 measure reflecting the proportion 

of variance that is explained in a con 

ventional regression model is not ap 

plicable to the loan outcome model. 

One measure of the predictive ability 

of qualitative response models is the 

proportion of correct predictions, 

where an observation is predicted to 

equal 1 if the estimated probability 

exceeds 0.5. However, this fit mea 

sure is flawed. For example, if a suf 

ficiently large proportion of values in 

the sample equals 1, one might obtain 

a higher prediction rate by assuming 

that all observations equal 1. The fact 

that a naive model may result in a 

higher prediction rate does not imply 

that the model is defective. Similarly, 

a high prediction rate itself does not 

necessarily indicate that the model is 

correctly specified or meets other 

goodness of fit criteria.27 

Munnell etal. note that 89 percent 

of loan outcomes are correctly catego 

rized based on a comparison of actual 

loan outcomes against predicted out 

comes, where a predicted outcome is 

determined by whether the denial 

probabilities exceed 50 percent. 

Models with alternative specifica 

tions reported by the Boston Fed, in 

cluding models that exclude PMI 

rejections, generate similar propor 

tions of correct predictions. How 

ever, if one were to assume that all 

applicants are approved, 85.5 percent 

of applicants would be correctly cate 

gorized (given the 14.5 percent rejec 

tion rate for the entire Boston Fed 

sample). Using a slight variation of 

this naive model, if one assumed that 

applicants are approved unless PMI is 

denied, 89 percent of all applicants 

would be categorized correctly with 

out any additional information simply 

because most mortgage applications 

are approved unless the PMI is re 

jected. 

A more detailed view of the good 

ness of fit measure used by Munnell 

et al. can be seen by comparing the 

predictions with actual outcomes for 

the sample corresponding to FDICsupervised institutions. The num 

bers are provided in Table 2. The 

proportion of applications denied, 

14.7 percent, is close to the 14.5 per 

cent rejection rate for the entire Bos 

ton Fed sample. Of the 205 

applications denied, 139 (67.9 per 

cent) had denial probabilities below 

"A higher monthly housing expense-to

income ratio or a higher total obligatians-to-in

come ratio (or both) may be acceptable for 

mortgages that have loan-co-value ratios of 90 

percent or less if the borrowers: are making a 

large down payment toward the purchase of che 

property; have a demonstrated ability to devote 

a greater portion of income to basic needs like 

housing expenses; have a demonstrated ability 

to accumulate savings and to maintain a good 

credit history or a debt-free position; have a 

potential for increased earnings and advance 

ment because of their education or job training, 

even though they have just entered the job 

market; have net worth substantial enough to 

evidence their ability to repay the morgage." 

FannieMaeSellingGuide{Van VI: Underwriring 

Guidelines), pp. 655-56. This listing represents 

a selection of the compensating factors that are 

listed, 

Munnell el a/., p. 3. 

Problems with this goodness of fit mea 

sure are discussed in derail by Amemiya (1981) 

and Greene (1990). 

10 
Mortgage-Lend ing Bias 

50 percent. Most of these observations appeared on the exception list distributed 

by the Boston Fed. The remaining 66 denied applications (32.3 percent) were 

associated with denial probabilities above 50 percent. In other words, approxi 

mately two-thirds of the applications that were denied were predicted to be 

approved on the basis of a 50 percent probability threshold. 

Table 2 

Actual Versus Predicted Outcomes 

Number Predict: Approve Predict: Deny Totai 

Actual Denied 139 66 205 

Actual Approved 1172 16 1188 

Totals 1311 82 1393 

The role of PMI in the distribution of probabilities generated by the Boston 

Fed model is particularly interesting. Forty-nine of the 66 applications correctly 

categorized as denials were in fact denied on the basis of PMI. Of the remaining 

156 rejected applications where PMI was not a factor, 17 (66 minus 49) had denial 

probabilities greater than 50 percent and 139 had denial probabilities of 50 percent 

or less. In other words, excluding PMI rejections, the model correctly categorized 

17 of 156 mortgage rejections, an 11 percent successful prediction rate for this 

group. 

Table 3 

Estimated Denial Probabilities 

Circumstances Probabilities 

Well-qualified applicant 3.5% 

(a) Zero net worth 3.4% 

(b) Delinquent credit 28.0% 

(c) Insufficient income 6.9% 

(d) Combined deficiencies 43.6% 

Closely related to the issue of model fit is the question of how well the 

probabilities generated by the model correspond to the underwriting process. 

The file examinations demonstrated that many of the rejected applications that 

were associated with low denial probabilities, applications that appeared on the 

exception list produced by the Boston Fed, exhibited numerous serious deficien 

cies. This is particularly important given the use of statistical models to identify 

applications that have been rejected wrongfully. In some cases the low denial 

probabilities are attributable to data errors. In others, the parameter estimates 

from the statistical model give relatively little weight to important factors that 

might be sufficient to justify a rejection. The influence of underwriting factors 

on the denial probabilities are illustrated in Table 3. The numbers suggest that 

the probabilities generated by the model do not appear to be consistent with 

underwriting guidelines. 

The impact of different categories of loan application weaknesses can be 

illustrated by calculating the denial probabilities from the coefficient estimates in 

the Boston Fed model. For example, a white applicant with average values for 

most variables in the model (including housing expense at 22 percent of income 

and debt obligations at 33 percent of income), with above-average credit history 

(with one or two "slow pay" accounts and no late mortgage payments), purchasing 

a single-family house with an 80 percent loan-to-value ratio (for which PMI would 

not be required) would be assigned a denial probability of 3.5 percent. As 

expected, the probability that this application would be denied is quite low. 

To illustrate how well the model re 

flects the underwriting process, de 

nial probabilities were generated 

using the coefficient estimates for 

four additional applicants with identi 

cal attributes except for the following: 

(a) zero net worth, (b) delinquent 

credit, (c) insufficient income, and (d) 

a combination of all of these prob 

lems. The resulting probabilities are 

illustrated in Table 3.2a 

The applicant used as the point of 

reference in the comparisons is un 

likely to be denied, given the denial 

probability of 3.5 percent. Individual 

(a) reports a net worth of zero. The 

denial probability for this application 

is not significantly influenced by the 

lack of assets because the model coef 

ficients on the net wealth/liquid as 

sets variables are not statistically 

different from zero.29 Individual 

(b) has overdue balances on seven 

credit cards, a student loan in the 

process of collection, a car loan in 

default, serious delinquencies with 

90 days past due and numerous late 

mortgage payments. (The consumer 

credit and mortgage credit variable 

values in this case are and 4 respec 

tively, the worst possible scores.) 

The impact of these factors is that 

the denial probability increases to 

28.0 percent. Despite the magni 

tude of such credit problems, the 

model implies that an application 

with these deficiencies will be ap 

proved more than two out of three 

T"he estimated probability of denial (pi) 

associated with a set of values for the explana 

tory variables (xi) can be calculated for the logit 

model from the parameter estimates 

Pi exp (p'xi)/[! + exp (p'xi] (see Maddala, 

1983). The probabilities were calculated using 

ihe mean values of the explanatory variables 

unless otherwise indicated. The parameter es 

timates from the Boston Fed model are pro 

vided in the appendix. 

However, if the point estimate in the 

model were used, the denial probability would 

fall to 3.4 percent with the decrease in net worth 

[although one would expect a decline in net 

worth to increase the probability of denial). 

II 
FDIC Banking Review 

times. If consumer credit problems 

arc reported in public records, the de 

nial probability increases to 56.3 per 

cent. Individual (c) has insufficient 

income, which is demonstrated by 

two ratios. In this case, the housing 

expense/income ratio rises to 50 per 

cent (well-above the Fannie Mae 

benchmark of 28 percent) from 20 

percent and debt obligations rise to 

50 percent of income (compared to 

the Fannie Mae 36 percent obligation 

ratio benchmark) from 30 percent.30 

The denial probability projected for 

this individual rises to only 6.9 per 

cent. Large increases in these ratios 

have little impact on the likelihood of 

denial. 

Finally, individual (d) reflects a 

combination of these problems: zero 

net worth, credit history and mortgage 

credit scores observed in (b), and the 

housing expense and obligation ratios 

specified in (c). Given all these prob 

lems combined, each of which would 

normally be expected to produce a 

lender denial, the denial probability 

generated by the model is 43.6 per 

cent. This implies that an application 

with these characteristics would be 

accepted more than half of the time; 

thus, the application would appear on 

the Boston Fed's exception report if 

denied. 

Two circumstances that generate 

high rejection probabilities in the 

model are (1) a public record in con 

junction with poor credit history and 

mortgage credit, and (2) PMI rejec 

tion. If the application characterized 

in (d) were supplemented by a public 

record of credit problems (defaults, 

foreclosure or bankruptcy), the denial 

probability would increase to 72.0 

percent. Alternatively, if the applica 

tion were identical to (d) except for a 

PMI rejection, the probability of re 

jection would rise to 98.8 percent. 

The illustrations suggest that even 

when the primary factors clearly ap 

pear to warrant a denial, the effect on 

the denial probability is relatively 

weak except when serious credit his 

tory problems and late mortgage pay 

ments are accompanied by a public 

record, or when PMI is rejected. The 

probabilities generated by the model 

do not appear to reflect our under 

standing of the underwriting process; 

based on these probabilities, many 

applicants with serious problems 

would be likely to obtain mortgage 

loan approvals. 

The race effect observed in the 

statistical model could be caused by a 

number of factors other than lending 

discrimination. First, the reviews 

demonstrated the substantial magni 

tude of the data errors. Some of these 

errors appear likely to introduce sys 

tematic bias into the model. The 

creditworthiness of rejected appli 

cants is likely to be overstated be 

cause (a) some institutions reported 

the original, unverified data on the 

original application, regardless of loan 

outcome or receipt of additional infor 

mation, and (b) the verification pro 

cess is normally terminated after 

sufficient deficiencies are found to 

justify a rejection. Second, the loan 

outcome variable in some circum 

stances does not accurately reflect the 

willingness of a lender co provide fi 

nancing. The loan outcome is re 

ported as a rejection if an applicant is 

overqualified for an affordable hous 

ing program, if PMI is not obtained, or 

if the applicant rejects a lender's 

counteroffer. Third, a number of im 

portant variables were not adequately 

captured in the statistical model, in 

cluding the amount of financial gifts 

and home equity. For the reasons dis 

cussed in this paper, these factors may 

result in an overestimation of the race 

effect on the lending decision. Fi 

nally, the model specification does 

not reflect the complex functional 

forms and interactions among vari 

ables implied by underwriting guide 

lines, particularly to the extent that 

compensating factors are evaluated 

for marginal applicants. The 

misspecification may produce biased 

coefficients, although the direction of 

the bias on the race estimates is inde 

terminate. Many of these problems 

are common to all of the alternative 

model specifications presented by the 

authors. As a result, the extent to 

which the race effectgenerated by the 

models reflects lending discrimina 

tion is uncertain. 

Conclusions and Policy 

Recommendations 

As Munnell etal. have observed, it 

is difficult to identify lending discrim 

ination through existing examination 

procedures. FDIC examiners re 

viewed rejected applicant files on the 

Boston Fed exception report to deter 

mine whether the rejections were jus

tified, and compared rejected 

minority applications to white appli 

cants with similar applicant character 

istics where possible. No evidence of 

discrimination was found. However, 

in many instances comparable files 

could not be identifed, making it dif 

ficult to determine whether the 

applicants' race influenced the under 

writing decision. 

The regression approach can be 

used to estimate the weights that 

apply to each factor considered by 

lenders, holding the influence of 

other factors constant. The statistical 

analyses performed by the Boston 

Fed identified a race effect that ap 

peared to be consistent with lending 

discrimination. However, the re 

views of loan files uncovered a num 

ber of problems with the statistical 

model. These considerations imply 

that there is insufficient information 

to determine what factors are respon 

sible for the higher minority rejection 

rates identified by Munnell et a/. 

These problems need to be addressed 

in future research to determine 

whether the race effect indicates 

lending discrimination, or whether 

the effect is an artifact of data and 

specification problems. 

Given the difficulties in determin 

ing lending bias from a detailed statis 

tical analysis of complete HMDA data 

supplemented by additional survey 

information, it is doubtful that rejec 

tion rates alone can identify institu 

tions that discriminate based on race. 

3 Note that the impact of a housing expense 

ratio of 31 percent is no different from a ratio of 

99 percent because the dummy variable for the 

ratio is 1 when the ratio exceeds 30 percent. 

The obligation ratio is included as a percent. 

This alleviates the problem of the high correla 

tion between the housing expense ratio and the 

total obligation ratio (which includes projected 

housing expense). 

12 
Mortgage-Lending Bias 

In some instances relatively high re 

jection rates reflect active community 

outreach programs, not lending bias. 

For example, 47 percent of all minor 

ity rejections (47 of 99) at the 70 

FDIC-supervised institutions partici 

pating in the Boston Fed study were 

attributable to a single minorityowned institution. However, despite 

this institution's high minority rejec 

tion rate (50 percent of all minority 

applicants were rejected at the insti 

tution), racial discrimination would 

appear to be an unlikely factor given 

that (1) the institution was the only 

minority-owned institution in the 

Boston area, and (2) 82 percent of 

mortgages approved by this institu 

tion were for minority applicants. 

The methodological problems as 

sociated with evaluating the role of 

race in mortgage lending also apply to 

many other types of financial services. 

Legislation recently has been intro 

duced to require banks to disclose in 

formation on small-business 

applications received from minorityowned businesses, for example, 

which essentially would extend 

HMDA reporting requirements to 

small-business lending. Analysis of 

lending based on race without ade 

quately controlling for the appropri 

ate financial information that reflects 

lending risk is subject to the pitfalls 

identified in this paper. Similarly, the 

questions concerning what data to 

collect and how to model lending de 

cisions remain unanswered. 

This paper has shown that the use 

of statistical analysis of loan files to 

infer racial discrimination is quite dif 

ficult. This suggests that investiga 

tion of loan files may be especially 

important in the compliance exami 

nation process. Comparisons be 

tween the demographic composition 

of an institution's market area and the 

racial and ethnic mix of loan applica 

tions reported by that institution may 

raise questions that require further in 

vestigation by a compliance exam 

iner. Scrutiny of loan files may reveal 

whether the loan documentation is 

appropriate, whether reporting is ac 

curate, and whether loan decisions are 

consistent with underwriting guide 

lines. Moreover, a detailed examina 

tion of individual loan files is likely to 

be necessary to confirm evidence of 

lending discrimination that may arise 

from statistical analysis of an 

institution's mortgage-lending data. 

In addition to data errors, which never 

will be completely eliminated, many 

loan decisions are influenced by fac 

tors that are difficult to capture in a 

statistical model. This may be a par 

ticular problem for lenders processing 

relatively few minority applicants, be 

cause the rejection ratios can change 

dramatically in response to a small 

number of loan outcomes. Although 

appropriately-specified statistical 

models may prove to be useful to in 

dicate potential lending problems, 

the statistical results may not be suf 

ficiently reliable to shed light on the 

creditworthiness of individual appli 

cations. 

13 
FDIG Banking Review 

REFERENCES 

Amemiya, Takeshi. "Qualitative Response Models: A Survey." Journal of Economic Literature 99 

(December 1981), 1483-1536. 

Apgar, William C. Jr., Denise DiPasquale, Jean Cummings and Nancy McArdle. The State ofthe Nation's 

Housing. Cambridge, MA: Joint Center for Housing Studies, Harvard University, 1990. 

Avery, Robert B., Patricia E. Beeson and Mark S. Sniderman. "Home Mortgage Lending by the 

Numbers." Federal Reserve Bank of Cleveland Economic Commentary, February 1993. 

Canner, Glenn B., and Dolores S. Smith. "Expanded HMDA Data on Residential Lending: One Year 

Later." Federal Reserve Bulletin 78 (November 1992): 801-24. 

Canner, Glenn B., and Dolores S. Smith. "Home Mortgage Disclosure Act: Expanded Data on Residen 

tial Lending." Federal Reserve Bulletin 77 (November 1991): 859-81. 

Cummins, Claudia. "Regulators Still Awarding High CRA Exam Scores." American Banker, 20 July 1993, 

p. 18. 

Federal National Mortgage Association. Fannie Mae Selling Guide. Washington, DC: Federal National 

Mortgage Association, 1990. 

Federal Reserve Bank of Boston. Closing the Gap. 1993. 

Fronczek, Peter J., and Howard A. Savage. Who Can Afford to Buy a House? Current Housing Reports, 

Series H121/91. Washington, DC: U.S. Department of Commerce, Bureau of the Census, 1991. 

Galster, George C. "Research on Discrimination in Housing and Mortgage Markets: Assessment and 

Future Directions." Housing Policy Debated (No. 2,1992): 639-83. 

Greene, William H. Econometric Analysis. New York: Macmillan Publishing Company, 1990. 

Judge, George G., W. E. Griffiths, R. Carter Hill, Helmut Ltitkepohl and Tsoung-Chao Lee. The Theory 

and Practice ofEconometrics, second ed. New York: John Wiley and Sons, 1985. 

Kennickell, Arthur, and Janice Shack-Marquez. "Changes in Family Finances from 1983 to 1989: 

Evidence From the Survey of Consumer Finances." Federal Reserve Bulletin 78 (January 1992); 1-18. 

Maddala, G. S. Limited-Dependent and Qualitative Variables in Economics. New York: Cambridge Univer 

sity Press, 1983. 

Maddala, G. S., and Robert P. Trost. "On Measuring Discrimination in Loan Markets." Housing Finance 

Review 1 (July 1982): 245-68. 

Munnell, Alicia H,, Lynn E. Browne, James McEneaney and Geoffrey M. B. Tootell. Mortgage Lending 

in Boston: Interpreting HMDA Data. Working Paper 92-7, Federal Reserve Bank of Boston, October 

1992. 

National Association of Realtors. Survey of Homeowners and Renters: Key Findings. Washington, DC: 

National Association of Realtors, October 1992. 

Perle, Eugene D., Kathryn Lynch and Jeffrey Horner. "Model Specification and Local Mortgage Market 

Behavior." Paper presented at the 21st Midyear Meetings of the American Real Estate and Urban 

Economics Association, June 1993. 

Schafer, Robert, and Helen F. Ladd. Discrimination in Mortgage Lending. Cambridge, MA: MIT Press, 

1981. 

Yinger, John. "Discrimination in Mortgage Lending: A Literature Review and Recommendations for 

Future Research," Paper presented at the Home Mortgage Lending and Discrimination Confer 

ence, Washington, DC, May 1993. 

14 
Mortgage-Lending Bias 

APPENDIX 

Determinants of Mortgage Loan Denials: 

Boston Fed Model Coefficients 

The coefficients from the Boston Fed regression are provided in the left-hand column 

of numbers. The statistics in the right-hand column illustrate the statistical significance 

(where significance at the 95 percent level is indicated by a t-statistic greater than 2). The 

estimated probability of denial ( pi) associated with a set of values for the explanatory 

variables in the logit model, (xj), is calculated for an individual applicant by multiplying 

each of the coefficients from the model ( pi) by each value of the explanatory variables 

that correspond to the individual application. Care must be taken to use the same scales 

as the model. For example, the housing expense is 0 if the housing expense ratio is less 

then .30 and 1 otherwise. In contrast, the debt payment (or obligation) ratio is included as 

a percentage* 100 (e.g., 33.46, the mean obligation ratio). The sum of the products 

(coefficients times variable values), indicated by the notation xi, is substituted in the 

following formula to obtain the denial probability for the individual: 

pi = exp (pSci)/[l exp (pSq)]. 

15 
FDIC Banking Review 

Risk Measurement, 

Actuarially-Fair Deposit Insurance 

Premiums and the FDIC's Risk-Related 

Premium System 

by Gary S. Fissel* 

One of the important deposit 

insurance reforms required by 

the Federal Deposit Insur 

ance Corporation Improvement Act of 

1991 (FDICIA) is theestablishmentof 

a risk-related pricing system. Under 

such a system, an insured institution's 

deposit insurance premium is related 

to the degree of risk that it poses to its 

insurance fund. The FDIC's riskrelated system went into effect on 

January 1, 1993. 

For the first 60 years of the FDIC's 

existence, all insured depository insti 

tutions were assessed at the same flat 

rate for their deposit insurance cover 

age. Under a flat-rate system, insti 

tutions can increase their risk to the 

insurance fund without incurring any 

additional premium expenses. This 

has two undesirable effects. The first 

is an equity issue. We11-managed, 

well-capitalized institutions subsidize 

the deposit insurance coverage of risk 

ier institutions. This is in contrast to 

most private insurance arrangements 

whereby lower-risk groups are re 

warded with lower premium rates. 

Secondly, under a flat-rate system, de 

pository institutions do not have to 

compensate either the insured depos 

itors or the deposit insurer for taking 

additional risk. As a result, there is an 

incentive for greater risk-taking and 

depository institution failures can be 

more frequent and more cosdy to the 

FDIC 

There is widespread agreement that 

a properly designed risk-related pre 

mium system would mitigate the in 

equities and the incentives toward 

greater risk-taking associated with the 

flat-rate pricing system. The risk-re 

lated system offers the possibility of 

improving the deposit insurance sys 

tem by acting as a complement to 

other measures that limit the risktaking behavior of insured depository 

institutions. 

The success that a risk-related de 

posit insurance pricing system has in 

attaining these objectives can be eval 

uated in two ways. In the ideal case, 

each institution's premium would be 

actuarially fair so that expected pre 

mium revenues equal expected costs. 

It is also possible that the objectives 

described above can be attained to 

some degree by a premium system 

that correctly ranks insured institu 

tions in terms of their relative riski 

ness. This paper estimates 

actuarially-fair premiums and evalu 

ates the existing FDIC risk-related 

premiums, both in absolute terms and 

as a ranking of relative risk. The 

analysis indicates that the existing 

eight basis point spread between the 

lowest and highest premium rates is 

too narrow to accurately reflect the 

range of risk confronting the FDIC. 

In terms of ranking relative risks, 

however, the FDIC system performs 

fairly well. 

The FDIC's risk-related premium 

system is presented in the next seclion. The degree of equity in the de 

posit insurance pricing system is 

directly related to how well the sys 

tem is able to measure the riskiness of 

insured institutions and the degree to 

which the measured risk is reflected 

in the differential pricing between in 

stitutions. Subsequently, a propor 

tional hazards model (PHM) is 

presented, which is used to estimate 

the expected time-to-failure for in 

sured institutions, from which actuar

ially-fair premiums are derived. 

Next, the FDIC's risk-related pre 

mium system is compared to these 

actuarial ly-fair deposit insurance pre 

miums. Concluding statements are 

made in the final section. 

'Gary S. Fissel is a financial economise in 

the FDIC's Division of Re search and Statistics. 

The author thanks Arthur Murton, George 

French and Frederick Cams for their insightful 

comments during the development of this 

paper. The author also rhanks Jennifer Eccles 

for her help on issues dealing with the BIF 

recapitalization. Finally, the author would like 

to thank Cathy Wright for her secretarial assis 

tance. 

yStt Blair and Fissel (1991) for a detailed 

discussion of the conceptual framework for a 

risk-related deposit insurance premium system. 
Risk-Related Premiums 

The FDIC's Risk-Related Premium System 

The risk-related premium system developed by the FDIC measures risk in two 

dimensions. One is capital and the second is supervisory judgment. Insured 

institutions are assigned to insurance risk groups on che basis of these two risk 

measures. 

Capital is important to the insurer because it provides a cushion against adverse 

changes in a depository institution's asset quality and earnings. In this sense, 

capital is a deductible for deposit insurance. Therefore, the more capita] an 

institution has, everything else being equal, the lower is its probability of failure. 

This result has been supported in numerous bank-failure and early-warning 

studies. 

Capital is a static view of an institution's risk at a moment in time, gauging its 

ability to survive negative shocks to its balance sheet over the near term. How 

ever, capital by itself does not give a complete picture of a depository institution's 

risk to its insurance fund. An institution's ability to survive is dependent also on 

its ability to maintain its capital base. Thus, capital needs to be complemented 

by other views of an institution's balance sheet and operations, such as asset 

quality, earnings, overall portfolio risk and management quality. These factors 

are consolidated into a risk measure referred to as a supervisory evaluation. 

The capital categories are defined by a set of three capital benchmarks per 

category, as outlined below. 

Benchmarks 

Noie: 'ge' is 'greater than or equal to'; 'It' is 'less than.' 

An institution must meet all three benchmark ratios to be admitted to its 

corresponding capital group. Given this, institutions are assigned to the highestlevel capital group for which they qualify. 

Within their respective capital groups, institutions are assigned to one of three 

supervisory subgroups, based on all of the information available to the FDIC and 

the primary federal regulator. The supervisory subgroups are defined as fol 

lows:3'4 

Subgroup 'A'. Institutions that are financially sound with only a few minor 

weaknesses. This generally corresponds to a composite CAMEL/MACRO rating 

of 1 or 2. 

Subgroup 'B'. Institutions with weaknesses that, if not corrected, could result 

in significant deterioration of the institution and increased risk to the insurance 

fund. This generally corresponds to a CAMEL/MACRO rating of 3. 

Subgroup 'C. Institutions that pose a substantial probability of loss to the 

insurance fund unless corrective action is taken. This generally corresponds to a 

CAMEL/MACRO rating of 4 or 5: 

Table 1 

1993 FDIC Risk-Related Premium Rates* 

Supervisory Rating 

Capital Rating A B C 

1 23 bp 26 bp 29 bp 

2 26 bp 29 bp 30 bp 

3 29 bp 30 bp 31 bp 

•These risk-related premium rates were approved by che FDIC's Board of Directors for the 

first and second assessment periods of 1993. 

Table 1 shows the risk-related pre 

mium system's insurance groups. 

Each institution is assigned to an in 

surance group based on its capital 

group and supervisory subgroup. 

The rate table is a three-by-three ma 

trix in which the higher-risk institu 

tions are placed in insurance groups 

that are to the south and/or east of 

their lower-risk counterparts. 

As an initial check on the risk mea 

sures used in the risk-related pre 

mium system, the failure rates of 

commercial banks for each cell of the 

matrix are presented in Table 2. 

Using reported financial information 

and composite CAMEL ratings as of 

December 31, 1987, banks were 

placed in their respective insurance 

groups. The failure rates are the per 

centage of institutions in a particular 

cell that failed by December 31,1992. 

The measurement of risk for the 

risk-related premium system is sup 

ported by the FDIC's experience 

with bank failures over this period of 

time. For every insurance group in 

Table 2, panel A, the adjacent eel! to 

the east and/or south has a substan 

tially higher failure rate. This is 

consistent with ehe higher premium 

'Sit Whalen (1991), Lane, stal. (1986), Ma 

rino (1984), Bovenzi,«a/. (1983), Sinkeyl 1978), 

and Sanromeroand Vinso (1977). 

These definitions can be found in the Ftd

eral Repsur, Volume 57, No. 191, October 1, 

1992. 

In accordance with the Inier-agency Uni 

form Financial Institutions Rating System, each 

institution is assigned a rating based on an eval 

uation of pertinent financial and opetational 

standards, criteria and principles. To aid in 

implementing the uniform rating system, five 

key performance dimensions are assessed and 

assigned a numerical rating. The rating for each 

dimension is through the use of a numerical 

scale of "1" through "5" in ascending order of 

supervisory concern; "1" indicates the highest 

rating and least degree of concern, while "5" is 

the lowest raring and the highest degree of 

concern. The performance dimensions are 

identified by the acronym "CAMEL": Capital 

adequacy, Asset quality, Management, Earn 

ings and Liquidity. An assessment of these 

performance dimensions and their interrela 

tionships represents the essential foundation on 

which the composite CAMEL rating is based; it 

is not simply an arithmetic average of the indi 

vidual performance dimension ratings. 

17 
I 

FDIC Banking Review 

rates paid as institutions move to the 

south and/or east in the table. 

Table 2, panel B presents a more 

disaggregated breakdown of the super 

visory subgroups into the composite 

CAMEL rating categories. Panel B 

also shows the supervisory risk evalua 

tion to be consistent with the ultimate 

failure of institutions. With the excep 

tion of two cases, groups 21 and 31 

(capital group-safety rating subgroup) 

where movements to the adjacent cell 

to the east lead to a decrease in the 

failure rates, a movement from any cell 

to an adjacent cell to the south and/or 

east leads to an increase in the failure 

rate. 

The failure rates in Table 2 provide 

evidence regarding the variations in risk 

across the various capital and super 

visory classifications.. As discussed 

above, panel A shows that commercial 

bank failure rates increase when 

institutions' capital group or supervisory 

subgroup is downgraded leaving the 

other rating unchanged, or when both 

the capital group and supervisory sub 

group are downgraded. The remain 

ing direction to be explored relates to a 

downgrade of institutions' capital group 

or supervisory subgroup and the up 

grade of the other, representinga move 

ment to the southwest and northeast, 

respectively. As indicated in Table 1, 

banks pay the same premium ratealong 

the southwest-to-north east diagonals of 

the rate matrix. Equity considerations 

would suggest that failure rates for 

these cells should be the same. There 

are only four moves from southwest to 

northeast that can be made in panel A, 

three of which result in failure rate de 

creases that average 2.058 percent and 

one increase of3.033 percent. In short, 

changes in failure rates along these di 

agonals are not substantial. 

Overall, the data on commercial 

bank failure rates presented in Table 

2 are consistent with the measures of 

risk that are used by the FDIC in the 

risk-related premium system. As the 

capital groups and supervisory sub 

groups are currently defined, failure 

rates from 1988 through 1992 increase 

for higher-risk institutions designated 

as having higher risk under the pre 

mium system. 

Table 2 

Commercial Bank Failure Rates: 1/1/88 through 12/31/92*1' 

Panel A 

"The sample includes only BIF-insured commercial banks that were aclive as of 

Decembci31,1987. 

"The supervisory ratings are based on composite CAMEL ratings as of December 31,1987, 

and the capital racings are based on reported capital as of December 31,1987. 

"Actuarially-Fair" Deposit Insurance Premiums 

A general principle underlying most insurance pricing schemes is that an 

insured is assessed a premium over the life of the insurance contract such that the 

expected revenue collected by the insurer from the insured is at least equal to the 

expected cost to the insurer from the insured's claims. 

[1) E(Cost) < E(Revenue) 

An actuarially-fair premium is defined in this paper as the premium at which 

equation (1) holds with equality. That is, an actuarially-fair premium is one in 

which the discounted value of the premiums paid in every period over the life of 

the contract is expected to generate revenues for the insurer that will equal the 

expected discounted costs to the insurer from claims made by the insured over 

the life of the contract. 

To illustrate this point, consider the following example. An insurance contract 

is written with the following characteristics: (i) the contract is written for the life 

of the insured, (ii) the insured is assessed a premium that is paid at the beginning 

of every period over the lifetime contract, and (iii) the insurer makes a lump-sum 

payment to a beneficiary at the end of the assessment period during which the 

insured dies. In addition, we know the following characteristics about the 

insured's lifetime: (a) the insured will not live beyond two assessment periods, 

and (b) the insured has a 50 percent probability of not surviving past the first 

assessment period. Rewriting equation (1) for this contract yields: 

]X.5 

where C(t) is the insurer's cost (lump-sum payment) at the end of period t, R(t) 

is the insurer's assessment revenue received at the beginning of period t, and r is 

the periodic discount rate. The left-hand side of equation (2) is the present 

discounted value (PDV) of the insurer's expected cost for this insurance contract 

and the right-hand side is the PDV of the insurer's expected revenue. If the 

lump-sum payment is $100 and the periodic discount rate is three percent, then, 

setting R(1)=R(2)=R in equation (2) and solving for R, the actuarially-fair pre 

mium in each period would be $64.41. 

18 
■■■ 

Risk-Relaced Premiums 

The deposit insurance contract that the FDIG makes with a depository insti 

tution has features similar to the stylized life contract presented above. First, the 

deposit insurance contract generally extends over the lifetime of an insured 

institution. There are few cases in which the FDIG has withdrawn deposit 

insurance from an existing institution. Second, insurance premiums are owed to 

the FDIC at the beginning of each assessment period. Third, upon the failure of 

an insured institution the FDIC effectively makes a lump-sum payment to the 

insured creditors, and possibly other creditors, of the failed institution. With this 

deposit insurance contract, the condition for an actuarially-fair insurance premium 

is presented in equation (3). 

R(*) no = 

where f(t) is the probability that the insured institution fails during period t. 

depository institution's premium is set as a fraction of its assessment base in 

each assessment period. This fraction is referred to as the premium rate. In 

addition, the FDIC's insurance cost for a failed institution can be measured as a 

fraction of the institution's assets at the time of failure. Equation (3) is expanded 

to incorporate these conditions for the case in which the assessment base is gross 

assets. 

(4) 

(1+r)' 

where a is the ratio of the FDIG's loss to the book value of assets at the time of 

failure, Ao is the book value of the insured's gross assets at time 0, G is the insured's 

asset growth rate, and p is the actuarially-fair premium rate. The assumption that 

the assessment base is assets is for ease ofestimation and presentation. However, 

it is not expected that alternative specifications would alter the conclusions of this 

paper. 

Solving equation (4) for p gives the distribution. A PHM is a way to ex 

premium rate that the deposit insurer plicitly recognize the dependence of 

must charge the insured institution in institutions* lifetime distributions on 

every assessment period in the future these characteristics ("covariates") 

so that the expected cost of the and to estimate the relationship be 

insured's failure equals the expected tween them. This relationship be 

revenue collected by the insurer. tween the covariates and a bank's 

While differences in any ofthe param lifetime is examined using a paramet 

eters in equation (4) for two institu ric regression model in which its life 

tions will lead to different premium time has a distribution that is 

rates for those institutions, the pre dependent on the covariates. This 

mium rate should reflect the funda model is expressed in log-linear form 

mental riskiness of each institution to by equation (5). 

the insurer, which is captured by its (5) y = po probability of failure for each period 

in the future, f(t). The distribution where y is the natural logarithm of the 

of each insured institution's time-to- time-to-failure, (xi, X2,..., X7) are the 

failure, i.e., its lifetime distribution, is attributes of the bank that serve as the 

estimated in this paper using a propor explanatory variables for the model, 

tional hazards model (PHM). (pl, p2,..., p7) are the corresponding 

coefficients of the model, and Z is the 

natural logarithm of a baseline lifetime Proportional Hazards Model that comes from the Weibull distribu 

Depository institutions have tion. Essentially, the term cjZ corre 

unique financial and other character sponds to the role played by an error 

istics that determine their risk of fail term in more-conventional regression 

ure, and thus affect their lifetime models. Equation (5) is a general 

specification of the estimating equa 

tion from which estimates of p* = (|3o, 

Pl, P2 p"7) and <T are derived. 

These estimates of p will be denoted 

by b= (bo, bi, bi,... ,b7) and the esti 

mate of o will be denoted by s. 

Increases in the value of (p*o + P[Xi 

+ p2x2 + + p7X7), hereafter denoted 

by x'P, correspond to increases in the 

financial health of the bank. Having 

estimated the (Po, Pi, P2 , P7), and 

using the assumed distribution of in 

equation 5, one can compute for any 

given values of (xj, x2, —, x7) the prob 

ability that the time-to-failure will ex 

ceed any given value (see Appendix 

A). The resulting "survival func 

tion" plots, for each time t, the prob 

ability that the bank will survive 

beyond t. Figure 1 shows the sur 

vival function for the average failed 

and nonfailed banks in the estimation 

sample, which is discussed in the fol 

lowing section.6-7 

Specification of Model and 

Sample 

As mentioned above, parameters 

are estimated for the linear form of the 

PHM, shown by equation (5). The 

dependent variable ofthis PHM is the 

time-to-failure as recorded by the 

FDIC. Two specifications of a de 

pository institution's failure have 

been used in the literature. One 

specification is that failure is identi 

fied at the time of insolvency, an eco 

nomic event, and the second specifies 

failure at the time of closure, a regula 

tory event. The latter is chosen for 

this paper, and so it is the regulatory 

closure rule that is modeled here. 

The dependent variable is a bank's 

time-to-failure measured in semian 

nual units of time from January 1, 

1988 to its closure on or before De 

cember 31, 1992 for failed banks, or to 

The PHM is derived in greater detail in 

Appendix A. 

'Bank' hereafter refers to a BIF-insured 

commercial bank. 

It should be noted that because the model 

is estimated using five years of data, survival 

probabilities for times greater than ten semian 

nual periods are extrapolations chat should not 

be taken too seriously. 

19 
a designated censoring date, January 

16,1993 for nonfailed banks.8 

A concise set of explanatory vari 

ables is used to specify the time-to

failure model. The selected 

covariates represent factors on the 

balance sheet that identify a bank's 

current financial status, its ability to 

survive any current problems in its 

portfolio, and the expectations for the 

bank's regional economy. These 

covariates are: 

(i) a "problem bank" dummy vari 

able that takes a value of 1 for banks 

with a CAMEL rating of 4 or 5; 

(ii> a significantly or critically un 

dercapitalized dummy variable that 

takes a value of 1 for banks that are 

significantly or critically undercapital 

ized according to the prompt correc 

tive action regulation required by 

FDICIA; 

(iii) ratio of Tier 1 capital to gross 

balance-sheet assets; 

(iv) portfolio risk ratio: ratio of 

risk-weighted balance-sheet and offbalance-sheet assets to gross balancesheet and off-balance-sheet assets;9 

(v) ratio of noncurrent assets 

minus loss reserves to gross balancesheet assets; 

(vi) annualized recum-on-assets; and 

FDIC Banking Review 

(vii) leading indicator for regional 

economy: percentage change in resi 

dential housing permits from the pre 

vious year, measured at the state 

level. 

Covariates (i) and (ii) identify insti 

tutions that are under a relatively 

large amount of financial stress, and 

thus whose failure is more likely than 

their healthier counterparts. Covari

ate (iii) is a measure of capital, which 

serves as a buffer against failure for 

asset quality and earnings problems. 

Covariate (iv) is a measure of the risks 

embedded in an institution's asset 

portfolio, and (v) is a measure of assetquality problems relative to the re 

serves for losses set aside for these 

problems. Covariate (vi) is a measure 

of a bank's profitability. If earnings 

are positive, they can be added to the 

bank's loss reserves and/or to its capi 

tal base, and if negative they will drain 

capital. Finally, covariate (vii) is a 

leading indicator for state economic 

performance, and is intended to mea 

sure the anticipated future strength of 

[he local economy. While many 

banks operate in markets beyond 

their state economies, it is believed 

that this local market captures a pri 

mary segment of banks' business 

activities.10 The covariates are mea 

sured as of December 31, 1987. 

The sample of banks that was used 

for estimating the PHM consists of 

the largest bank within a holding com 

pany, the other institutions within a 

holding company that have assets of 

$500 million or more, and individual 

institutions that have no holdingcom

pany affiliation. In addition, these 

banks must be insured by the Bank 

Insurance Fund (BIF), they must 

have been active as of December 31, 

1985, and must have either failed or 

remained active as of December 31, 

1992. The sample selection rule that 

applies to the largest institutions 

within a holding company is used to 

remove failures of smaller banks 

within a holding company that often 

appeared to be healthy from their fi 

nancial reports, but that failed be 

cause of their affiliation and financial 

integration with the lead bank(s). 

This was the case particularly in 

Texas, which was a unit banking state 

until 1987." The subordinate banks 

within a holding company essentially 

served as deposit-gathering branches 

for the lead bank(s). The inclusion 

of subordinate bank failures of this 

type in the estimation sample could 

significantly bias and diminish the fit 

of the model.12 

Nonfailed institutions are treated as rightcensored observations by the PHM. 

Risk-weighted balance-sheet and off-bal 

ance-sheet assets are esiimared using the algo 

rithm developed by the Federal Financial 

Institutions Examination Council (FFIEC). 

10As pointed out in Whalen (1991), a bettet 

approach for measuring anticipated future local 

economic performance might be to use fore 

casts of local economic conditions from separate 

models. 

Texas branching laws were changed in 

1987, to allowfor limitedconsolidation of banks 

within the same holding company. Consolida 

tion was subsequently done to varying degrees 

by the multibank holding companies in the 

state. 

T'he difficulty with subordinate bank fail 

ures has been dealt wirh in a variety of ways. 

Some authors have not incorporated any adjust 

ments in their sample or model for the subordi 

nate banks. Some have added holding 

company variables to the bank-failure equa 

tions; for example, see Gajewski (1989) and 

Thomson (1989). Whalen (1991) adjusted the 

sample to exclude the smaller subsidiaries, less 

than or equal to $500 million, of the large Texas 

holding companies. 
Risk-Related Premiums 

The final estimation sample in 

cludes all of the failed and nonfailed 

banks that satisfied the selection cri 

teria discussed above. There are 571 

failed and 8,864 nonfailed institutions 

in the sample. Thus, the ratio of failedto-nonfailed banks equals 6.59 per 

cent. 

As in most failure-prediction stud 

ies, an institution is predicted to fail if 

its estimated probability of failing 

over a specified period of time ex 

ceeds the ratio of failed-to-nonfailed 

banks in the sample.13 Thus, institu 

tions with estimated five-year survival 

probabilities of less than 93.41 (i.e., 1 

6.59) percent are designated as fail 

ures. Figure 1 shows that the mean 

failed bank is predicted to fail within 

five years under this criterion, while 

the mean nonfailed bank is predicted 

to not fail: the five-year survival 

probabilities for the mean failed and 

nonfailed banks are approximately 69 

percent and 98 percent, respectively. 

Estimation Results 

The PHM fit and the estimated 

coefficients for covariates (i) through 

(vii), discussed above, are presented 

in Table 3. These are the coefficients 

that were used to construct Figure 1. 

All of the estimated coefficients 

have the correct sign and are signifi 

cant at the one percent level. For 

example. Tier 1 capital has a positive 

sign indicating that banks with more 

capital today have a higher probability 

of survival at every point in the future, 

while portfolio risk has a negative sign 

indicating that banks with greater risk 

on their balance sheets have a lower 

probability of survival, and thus a 

shorter expected lifetime. For the 

PHM with a five-year failure horizon, 

the data show that banks' portfolio 

In this paper, the sampling rates for failed 

and nonfailed banks are 100 percent for both 

types of institutions. The estimated parame 

ters, particularly [he intercept term, are af 

fected by the sampling proportions in the 

sample. A higher ratio of failed-to-nonfailed 

banks in the estimating sample will cause the 

Estimated survival probabilities of healthy insti 

tutions to be underestimated relative to what 

they would be with a lower ratio. &e Maddala 

(1983, pp. 90-91) and (1986) for a discussion of 

unequal sampling rates for two groups. 

Table 3 

PHM Estimates for Five-Year Failure Horizon 

1/1/88 through 12/31/92 

Parameter 

Intercept 

(i) Problem Bank, dv 

(ii) Undercapitalized dv 

(iii) Tier i Leverage 

(iv) Portfolio Risk 

(v> NonCurr-Res 

(vi) ROA 

(vii) H. Permits 

s 

Estimate 

9.96458460 

-1.08630100 

-0.55224400 

0.03197010 

-0.06788730 

-0.08689180 

0.06405025 

0.02777508 

0.88474607 

Std. Error 

0.397094 

0.106065 

0.123324 

0.012494 

0.004827 

0.012130 

0.011595 

0.002436 

0.031622 

Chi Square 

629.6973 

104.8947 

20.0526 

6.5476 

197.7644 

51.3121 

30.5144 

130.0181 

Pr > Chi Sq 

0.0001 

0.0001 

0.0001 

0.0105 

0.0001 

0.0001 

0.0001 

0.0001 

•The pseudo-Rmeasure, McFadden (1974), is equal to 1 minus the ratio of the 

log-likelihood value for the Full model and the log-likelihood value for the model with all of 

the parameters for the explanatory variables, (i> through (vii) above, equal to zero. 

"The classification criterion is approximately equal to 1 minus the ratio of 

failed-to-nonfailed banks in the sample, or 93 percent. Any bank having a probability of 

failure greater than seven percent, or a probability of survival less than or equal to 93 percent, 

at the five-year horizon is predicted to fail. This classification criterion is a standard 

approach in the bank-failure literature 

risk (iv) is the most important factor, 

based on the chi-square statistic, in 

explaining their failure time. This is 

followed by the asset-quality measure 

fv) and the problem-bank dummy 

variable (i), both of which are in 

versely related to a bank's expected 

lifetime, and the proxy for future local 

economic activity (vii), which is posi 

tively related to a bank's expected 

lifetime. 

The time horizon over which fail 

ures are estimated is an important fac 

tor in determining the variables that 

are most significant in the model. 

Similar to what has been discussed by 

Thomson (1991), over a short failure 

time horizon, say, two years, capital 

and earnings, along with the problembank dummy variable, are the most 

significant variables. However, over 

a longer horizon of five years, portfolio 

risk and asset-quality measures be 

come the most significant explanatory 

variables. In a broad sense, both port 

folio risk and the volume of troubled 

assets are measures of the downside 

risk of banks' portfolios. The former 

is a measure of the total inherent risk 

and the latter is the realized risk of 

these portfolios at some point in time. 

The overall fit of the PHM is good 

with a likelihood ratio statistic of 

998.8, which is significant well be 

yond the 0.01 percent level, and an 

adjusted R2 of 35.569 percent. The 

model has a type 1 error, not predict 

ing failure when failure occurred 

within a five-year failure time hori 

zon, of 18.56 percent and a type 2 

error, predicting failure when no 

failure occurred, of 11.69 percent. 

21 
FD1C Banking Review 

Figure 2 

Survival Probability 

1 

Group 1A 

(x'b=7.1647) 

Group 2B 

(x'b=6.0015) 

Group 3C 

{x'b=4.0914) 

20 40 60 80 100 120 140 160 1 SO 200 

rime (Semiannual Periods) 

The complements to these type 1 and mean IA bank is above that of the 

type 2 error rates are the correct pre mean 2B bank, which is above the 

diction rates for failed and nonfailed survival probability of the mean 3C 

banks in the sample, respectively. bank. These mean values are shown 

The model correctly predicted 81.44 in Table 4, aiong with the resulting 

percent of the bank failures lhat oc x'b value. 

curred within the five-year horizon, The financial characteristics of the 

and the model correctly predicted mean IA, 2B and 3C banks presented 

88.31 percent of the banks that did not in Table 4 are directly related eo the 

fail.14 survival profiles that are shown in Fig 

Consider the survival profiles of ure 2. The mean IA bank is a lowerthe three banks shown in Figure 2. risk institution than is the mean 2B 

The mean values for the covariar.es in bank, which is a lower-risk institution 

insurance groups IA, 2B and 3G are than the mean 3C bank. Comparing 

used with the estimated parameters of che average IA and 2B banks for each 

the PHM to generate their survival of the covariates in Table 4, the IA 

profiles. As one would expect, the bank has a higher capital ratio, lower 

estimated survival probability of the portfolio risk, a lower level of noncur

rent assets that are uncovered by re 

serves, a higher return-on-assets, and 

is from an area where economic trends 

appear more favorable, as measured 

by the change in housing permits. 

The same can be said for the average 

2B bank when comparing it with the 

average 3C bank. The risk of these 

institutions is summarized by their 

values for x'b, in which a larger value 

denotes a lower-risk institution, and 

results in a lower estimated premium 

rate. The FDIC's risk-related pre 

mium system is now examined in 

light of the premiums that are derived 

from the PHM. 

A Comparison ofRisk 

Measures 

This section estimates actuariallyfair insurance premiums using equa 

tion (4). The premium differentials 

between banks are driven primarily 

by the estimated probability of their 

failure time, f(t), and the ratio of the 

FDIC's loss to the book value of as 

sets at failure, a. The earlier a bank's 

estimated failure time and/or the 

greater is a, the larger will be the 

premium rate for that institution. In 

this paper, the FDIC's loss ratio is 

assumed to be the same for all institu 

tions, namely 14.479 percent, which is 

the (asset-weighted) average ratio of 

FDIC loss to the book value of gross 

assets from January 1, 1986 until De 

cember 31, 1992. In addition, the 

semiannual discount rate is assumed 

to be 3.865 percent, which is the aver 

age semiannual return on the FDIC's 

investments in U.S. Treasury debt in 

struments from 1986 through 1990. 

and the gross asset semiannual growth 

rate, 9, is assumed to be 1.5 percent. 

For simplicity, the assessment base in 

equation (4) is the bank's gross assets, 

An. This specification differs from 

the FDIC's actual assessment base of 

domestic deposits. 

The results are presented in Table 

5. Panel A compares the actuariallyfair premium rates estimated by the 

The cype 1 and type 2 error rates depend 

on the level of the classification criterion that is 

used to define a predicred failure. 

22 
Risk-Related Premiums 

•The accual premium rates are the rates used on ihe first and second assessment schedules 

of 1993 and are the same as the rates in Table 1, 

""The mean PHM-derived premium rates based on assets are converted to rates based on 

the current assessment base by dividing the piemium rates in panel by 0.644, the current 

BIF average ratio of assessable deposits-to-assers. This procedure ensures that equal 

revenue will be collecred by the mean PHM-derived premium rates in panels and B. 

•"The implicit "recapiralization tax" of 11 basis points is the premium necessary to 

increase the BIF from its current balance to the target ratio of 1.25 percent of insured 

deposits in the absence of any insurance losses, based on the estimated year-end 1993 

balance of the BIF and a recapitalization by 1998. 

Notes: (i) The number of banks is listed parenthetically for each insurance group. 

model (left side) with the rates expressed as basis points of domestic 

charged by the FDIC (right side). deposits, while those estimated by 

This comparison indicates that the the model are basis points of assets. 

rates charged by the FDIC are gener Moreover, the rates charged by the 

ally higher than the actuarially-fair FDIC for 1993 and 1994 reflect, in 

premium rates estimated by the part, the need to increase the BIF to 

model. Care is needed in making the required ratio of 1.25 percent of 

such a comparison, however, because insured deposits. 

the premium rates in panel A are not Panel B of Table 5 displays the 

directly comparable. In particular, results of adjustments designed to fa 

the rates charged by the FDIC are cilitate comparisons between the pre 

mium rates charged by the FDIC and 

chose estimated by the model. The 

left side of panel B presents the 

PHM-derived premium rates as basis 

points of domestic deposits instead of 

assets. This adjustment is not done 

on a bank-by-bank basis, but by in 

creasing all PHM-derived premium 

rates by the equal proportional 

amount that would be needed to gen 

erate the same FDIC revenue from 

the smaller assessment base of do 

mestic deposits rather than assets. 

The right side of panel B displays the 

results of subtracting, from the actual 

premium rates charged by the FDIC, 

an estimate of the implicit "tax" cur 

rently imposed on BIF members to 

recapitalize the BIF to 1.25 percent of 

insured deposits. This recapitaliza 

tion component of the insurance pre 

mium rates is currently estimated to 

be about 11 basis points of domestic 

deposits.15 The result of this subtrac 

tion is an estimate of what the FDIC 

is currently charging insured institu 

tions for "going-forward" risk. 

In short, the premium rates on the 

left and right sides of panel B can be 

compared legitimately. The FDIC's 

implicit risk-related premiums (that 

is, after the estimated recapitalization 

component is subtracted) generally 

are greater than the actuarially-fair 

premiums estimated by the model, 

but not by much. The average pre 

mium rate for the right side of panel 

B is 13.4 basis points, as compared to 

10 basis points for the PHM-derived 

premiums on the left.16 Subgroups A 

and B pay somewhat more than their 

estimated actuarially-fair premium 

rates, while subgroup C pays consid 

erably less. 

Table 5 also indicates that the risk 

rankings implied by the model are 

One can estimate the amount of ihe recap 

italization "tax" as the premium necessary to 

build the BIF from its current level to the re 

quired 1.25 percent of insured deposits, assum 

ing no bank-failure losses. Naturally, this 

amount depends on the speed with which the 

target is reached. For example, if recapitaliza 

tion occurs in 1997, the recapitalizaion compo 

nent of rhe premium is estimated to be 14 basis 

points, whereas if recapitalization takes the full 

15 years from 1991 that is allowed by FD1CIA, 

the amount is 4.3 basis points. 

The average premium rate equals the av 

erage rate weighted by the assessment base. 

23 
FDIC Banking Review 

consistent with those used by the 

FDIC. The actual premium rates in 

crease for movements to adjacent 

cells to the east and/or south. This 

reflects the increase in failure risk that 

is expected to characterize the institu 

tions in the insurance groups to the 

east and/or south. In general, the 

PHM-derived premium rates in 

crease for movements to the east 

and/or south along the schedules in 

panelsAandB.17'18 Thus, thePHM

derived premium rates are qualita 

tively consistent with the actual 

premiums in terms of risk rankings. 

However, there are differences be 

tween the two schedules in panel B in 

terms of the magnitude of the pre 

mium rate spreads between insurance 

groups. 

For the PHM-derived premium 

rate schedule in panel B, the rates 

range from 7.12 basis points for the 

lowest-risk insurance group, 1A, to 

107.51 basis points for the highest-risk 

group, 3C. The implication here is 

that the average bank in group 3C has 

a risk of failure that is about 15 times 

greater than the average 1A bank, and 

so the actuarially-fair premium rate 

would differ by the same order of 

magnitude, everything else being 

held equal. The spreads between 

the actual adjusted premium rates for 

the insurance groups range from 12 to 

20 basis points. Thus, the rate for the 

3C bank is only 1.67 times the rate for 

the 1A bank, a very small spread rela 

tive to the spreads for the PHM-de 

rived rates. 

Whi le a greater spread in premium 

rates in the FDIC's risk-related pre 

mium system appears to be supported 

from an actuarial perspective, the rate 

spreads may need to be constrained 

from a broader cost-minimization per 

spective or due to public-policy con 

siderations. That is, there may be an 

upper bound on the level of premium 

rates that the FDIC would want to 

charge to insure weak institutions. 

Deposit insurance premium assess 

ments that are so expensive that they 

become the primary cause of bank 

failures would likely increase the 

number of failures beyond what it 

might otherwise be, and so inflate 

Table 6 

Ordinal Risk Rankings (in ascending order) of Insurance Groups 

Insurance Group 

Rankings Adjusted for Small Sample Sizes** 

Risk Measures 1A IB 1C 2A 2B 2C 3A 3B 3C 

Actual Premium Rates* 1 24246— — 7 

PHM-Derived Premium Rates 1 2 5 3 4 6 — — 7 

Failure Rates 1243 5 6— — 7 

'See Table 1. 

"These ratings for insurance groups 3C and 3B 

respectively. 

costs for the FDIC, as well as cause 

unnecessary disruptions to the bank 

ing system. Nevertheless, there may 

be some room in the current FDIC 

premium rate schedule to increase the 

premium rate spreads between the 

lower- and higher-risk insurance 

groups, given the limitations noted 

above. Such an increase in spreads 

would have the benefit of lessening 

the deposit insurance pricing subsi 

dies to high-risk institutions and in 

creasing the overall equity of the 

system.19 

Panel C of Table 5 breaks the su 

pervisory subgroups in panel A into 

their underlying composite CAMEL 

rating components. In general, the 

PHM-derived rates illustrate the 

same increase in risk for insurance 

groups that are in adjacent cells to the 

east and/or south. This is similar to 

what was shown in panel A. In addi 

tion, it is interesting to compare the 

mean PHM-derived premium rates 

for the different composite CAMEL 

rating columns that have the same 

capital group rating. For every capi 

tal group, the average institutions in 

CAMEL rating categories 4 and 5 are 

significantly more risky than the aver 

age category 3 institution. There ap 

pears to be a distinct qualitative 

difference in the risk levels between 

these banks, and so this result sup 

ports the collecting of 4- and 5-rated 

institutions into their own supervisory 

subgroup, subgroup C. This contrast 

in rates is not as clear-cut for the aver 

age 1-, 2- and 3-rated institutions. 

However, it can be said that the esti 

mated rate differences between the 

mean 1- and 2-rated banks are slightly 

are based on only two and six observations, 

larger than that between the mean 

and 3-rated banks. 

Table 6 presents the ordinal rank 

ings of the risk-related insurance 

groups by the actual and PHM-de 

rived premium rates (Table 5, panel 

A) and by failure rates (Table 2, panel 

A), all adjusted for [he small sample 

sizes of insurance groups 3A and 3B.20 

A higher ordinal ranking corresponds 

to a higher premium rate and higher 

risk. The PHM-derived premium 

rates and the failure rates are consis 

tent with one another, with only the 

ordinal rankings of 4 and 5 being in 

terchanged for insurance groups 1C 

and 2B for the two risk measures. 

Moreover, both of these risk measures 

are consistent with the actual pre 

mium rate structure for the FDIC's 

risk-related premium system. Be 

cause the actual premium rate struc 

ture is designed to be symmetric with 

There is only one exception to this result. 

Insurance group 3A has a lower relative rate 

than any adjacent insurance group. Group 3A 

contains only two banks, and so not much con 

fidence should be placed in the estimated mean 

relative rate for this cell. 

Excluding insurance group 3A, there are 

only three movements io the northeast, repre 

senting a trade-off between a capital group up 

grade and a safety rating downgrade, that can be 

made for PHM-derived rates in Table 5, panel 

A. These are from group 2B to 1C and from 

group 3B to 2C, which result in increases in the 

average estimated premium rates and risks, and 

From group 2A to IB, which result? in a decrease 

in the average estimated premium rate and risk. 

L9Jffi Blaii and Fissel (1991). 

The unadjusted rankings are presented in 

Appendix B. 
Risk-Related Premiums 

regard to capital and safety ratings, its 

ordinal rankings of risk contain ties 

that are compatible with the rankings 

for the other risk measures. 

Conclusion 

The FDIC's risk-related premium 

system is an improvement over the 

traditional flat-rate pricing system for 

deposit insurance. The risk-related 

system moderates the pricing inequi 

ties that exist under the flat-rate sys 

tem, and imposes financial costs on 

depository institutions for increased 

risk-taking. The ability of a risk-re 

lated pricing system to realize these 

benefits is ultimately dependent 

upon its ability to evaluate the riski 

ness of insured institutions, and so to 

assess them accordingly for their de 

posit insurance. 

The FDIC classifies institutions 

into risk groups, or insurance groups, 

on the basis of capital and supervisory 

ratings, which encompass a wide 

range of information about banks as 

ongoing concerns. This paper has 

compared the risk-classification 

framework of the FDIC's risk-related 

premium system with an indepen 

dent risk measure that is derived from 

a proportional hazards model (PHM). 

The PHM-derived measure esti 

mates actuarially-fair premium rates 

based on each institution's expected 

time-until-failure. 

This paper has three principal 

findings. First, for most well-run in 

stitutions, actual premium rates 

charged by the FDIG are much higher 

than are the estimated actuarially-fair 

premium rates. This is, in part, at 

tributable to the requirement that the 

FDIC charge an average premium 

rate of at least 23 basis points until the 

BIF reaches its statutory target ratio 

of 1.25 percent of insured deposits. 

second and related finding is that 

the premium rate spread between the 

high- and low-risk institutions is sig 

nificantly narrower for the actual pre 

mium rates as compared with the 

actuarially-fair premium rates. In 

other words, current differences in 

premium rates between insurance 

groups do not fully reflect the differ 

ence in actuarial risk as estimated by 

the PHM. This may reflect a broader 

cost-minimization perspective: suf 

ficiently high premium rates may in 

crease the probability of failure to 

such an extent that the FDIC is made 

worse off by the high premium rates. 

Third, the risk rankings used by 

the FDIC's risk-related premium sys 

tem are generally consistent with 

those that were estimated by the 

PHM, as well as with historical failure 

rates shown in Table 2, panel A. 

This provides some comfort that the 

FDIC's risk-related premium system 

is a useful ranking of the relative risk 

of insured institutions. 

The information-intensive nature 

of the financial-intermediation pro 

cess makes risk measurement a diffi 

cult task. In addition, as stated 

above, the success of a risk-related 

premium system depends upon its 

success in ranking and measuring risk. 

The approach to risk classification in 

the FDIC's risk-related premium sys 

tem is generally consistent with the 

risk rankings derived in this paper. 

Thus, the risk-related premium sys 

tem should serve as a useful comple 

ment to other measures in 

safeguarding the deposit insurance 

funds. 

25 
FDIG Banking Review 

BIBLIOGRAPHY 

Blair, Christine E. and Gary S. Fissel. "A Framework For Analyzing Deposit Insurance Pricing." FDIC 

Banking Review (Fa\\ 1991): 25-37. 

Bovenzi, John F., James A. Marino and Frank E. McFadden. "Commercial Bank Failure Prediction 

Models." Federal Reserve Bank of Atlanta Economic Review (November 1983): 14-26. 

Gajewski, Gregory R. "Assessing the Risk of Bank Failure." In Federal Reserve Bank of Chicago 

Proceedings ofa Conference on Bank Structure and Competition, pp. 432-56, Chicago: n.p,, 1985, 

Kalbfleisch, John D. and Robert L. Prentice. Tke Statistical Analysis of Failure Time Data. New York: 

John Wiley Sons, 1980. 

Lane, William R., Stephen W. Looney and James W. Wansley. "An Application of the Cox Proportional 

Hazards Model to Bank Failure." Journal ofBanking and Finance 10 (1986): 511-31. 

Lawless, Jerald F. Statistical Models andMethodsfor Lifetime Data. New York: John Wiley Sons, 1982, 

Maddala, G.S, "Econometric Issues in the Empirical Analysis of Thrift Institutions' Insolvency and 

Failure." Federal Home Loan Bank Board, Invited Research Working Paper 56 (October 1986). 

, Limited Dependent and Qualitative Variables in Econometrics. New York: University Press, 

1983. 

Marino, James A. "Comparison of Failed and Healthy Banks' Capital Ratios." Federal Deposit Insurance 

Corporation Economic Outlook 2, 11 (November 1984): 2-5. 

McFadden, D. "The Measurement of Urban Travel Demand," Journal of Public Economics 3 (1974): 

303-28. 

Santomero, Anthony M. and Joseph D. Vinso. "Estimating the Probability of Failure for Commercial 

Banks and the Banking System." Journal ofBanking and Finance 1 (1977): 185-205. 

Sinkey, Joseph F., Jr. "Identifying Problem Banks: How Do the Banking Authorities Measure a Bank's 

Risk Exposure?" Journal ofMoney, Credit and Banking 10, 2 (May 1978): 184-93. 

Thomson, James B. "Predicting Bank Failures in the 1980V Federal Reserve Bank of Cleveland 

Economic Review Zlt 4 (1991, Quarter 1): 9-20. 

Whalen, Gary. "A Proportional Hazards Model of Bank Failure: An Examination of Its Usefulness as an 

Early WarningTool." Federal Reserve Bank of Cleveland Economic Review 27,4 (1991, Quarter 1): 

21-31. 

26 
Risk-Related Premiums 

APPENDIX A 

Proportional Hazards Model 

The relationship between a bank's lifetime and the covariates is specified in equation (Al): 

(Al) T = H(x)*Toa 

where (i(x) is a multiplicative scale factor and o is a power factor on lifetime, and To is a baseline 

lifetime. Letting u,(x) = exp(x'p), equation (Al) can be put into more convenient log-linear form, as 

shown by equation (A2): 

(A2) y = p\> + Pix: + p2x2 + + P7X7 + oZ 

where y=ln(T), Z=ln(To) and Z corresponds to the error term in more-conventional regression 

models. Assuming a distribution for To, estimates of P and can be found from either equation {Al) 

or (A2), which formalizes the relationship between a bank's lifetime and the covariates. 

Institutions' lifetimes are assumed to have a Wei bull distribution.21 The Weibull distribution is 

a two-factor distribution with parameters \i and a, as discussed above. The location of the 

distribution is dependent on the covariates, (J-(x), and so the survival function for T, given x, is given 

in equation (A3); 

(A3) S(t\X) = ProZ>(T>f) = cxp[-(-^-)/a] \i{x) 

Again, letting x'p = po +Pl*i +P2X2 + + P7X7 and setting u:(x) = exp(x'p")> the survival function, 

equation (A4), becomes: 

(A4) S{t\x)=Prob{T>t)= exp [- ( / ) '/c] 

The distribution of a bank's lifetime is characterized by its survival function, i.e., the probability 

that it survives up to and beyond some time t. From equations (A2) and (A4), an institution's 

expected failure time and the probability of its survival at various points in time increase as x*p 

increases. 

Graphical methods are used to check the validity of the fitted models and the adequacy of the Weibull distribution. 

The sample satisfies che following two requirements for graphical testing of the Weibull distribution. First, a plot of 

ln[-ln[S(t)J] versus ln[5] should be approximately linear if the Weibull distribution is appropriate. Second, similar plots of 

the sample that are broken into strata defined by components of the regression vector should be roughly linear with 

approximately the same slope. 

APPENDIX B 

Ordinal Risk Rankings (in ascending order) of Insurance Groups 

Insurance Group 

Rankings Unadjusted for Small Sample Sizes 

Risk Measures 1A IB 1G 2A 2B 2G 3A 3B 3G 

Actual Premium Rates3 12424747 9 

PHM-Derived Premium Rates 2 3 7 4 5 8 lb 6b 9 

Failure Rates 12536 748 9 

^he actual premium rates are based on the January 1, 1993 assessment schedule. 

HThese ratings for insurance groups 3A and 3B are based on only two and six observations, 

respectively. 

27 
FDIC Banking Review 

Bank Powers and the Separation 

of Banking from Commerce 

An Historical Perspective 

Bank regulation serves several 

purposes: to maintain finan 

cial stability; to avoid exces 

sive concentrations of power and 

unfair or unhealthy competition; and 

to protect consumers and advance so 

cial goals. While banks always have 

been subject to some form of regula 

tion, what has constituted "appropri 

ate" bank regulation has evolved over 

the course of American banking his 

tory. As such, the safeguards or fire 

walls that have been judged to be 

necessary and sufficient to serve the 

purposes of bank regulation also have 

evolved. 

Historically, American banking 

regulation has separated banking 

from other forms of commerce to vary 

ing degrees. Restrictions on the di 

rect powers of banks were included 

first in bank corporate charters and 

later in the definition of the "business 

of banking" as found in both state and 

federal legislation. Prohibitions 

against engaging in manufacturing or 

speculative real-estate holdings, for 

example, were included in many of 

the early bank charters. However, 

there has never been an absolute pro 

hibition on banks engaging in "com 

mercial" activities.1 

It is not surprising, therefore, to see 

the lines of separation in today's fi 

nancial markets blurring. Banks and 

their affiliates increasingly are in 

volved in activities from which they 

once were prohibited. Conversely, 

by Christine E. Blair* 

nonbank organizations increasingly 

engage in lines of business once dom 

inated by banks, 

The entry of insured depositories 

into nonbank lines of business makes 

it important to ensure that the federal 

safety net is not extended inappropri 

ately to these activities. "Firewalls" 

are the legal and economic barriers 

that are intended to prevent inappro 

priate flows ofcapital, funds and infor 

mation between affiliates. They 

facilitate the segmentation of func 

tions within an organization, and are 

designed to prevent the transmission 

of losses from one area of an organiza 

tion to another. Banking firewalls 

have been implemented for the pur 

pose of isolating the insured deposi 

tory from nonbank activities of the 

bank or its affiliates. The so-called 

"Chinese wall" that separates the 

trust function from the depository 

function of a bank is an example of a 

common banking firewall. Another is 

the set of restrictions on interaffiliate 

transactions in bank holding compa 

nies contained in the Federal Reserve 

Act. The source of most contempo 

rary firewalls is the banking legisla 

tion and regulatory guidelines 

instituted since the New Deal legisla 

tion of the 1930s. 

What is or is not "banking," and 

how to ensure the goals of bank regu 

lation, are once again subjects for de 

bate. The crux of the banking reform 

debates is how to provide for banks' 

viability without abusing the federal 

safety net. Consequently, whether 

banks can be effectively insulated 

from the risks posed by their affiliates 

is an important issue. Ultimately, the 

policies implemented by banking re 

form will reflect in substantial part the 

assumptions held concerning the role 

and performance of firewalls, These 

assumptions have evolved over time 

and likely will continue to do so, 

The purpose of this paper is to pro 

vide an historical perspective on bank 

powers and the separation of banking 

from commerce. While the papet is 

agnostic on the question of how best 

to structure and regulate bank pow 

ers, it is hoped that the information 

provided will facilitate informed de 

bate on these issues, In the sections 

that follow, the development of U.S. 

bank powers since the late 18th cen 

tury and the safeguards or firewalls 

limiting those powers are examined. 

This is followed by an overview of 

current rules governing the separation 

of banking from other activities. The 

final section contains concluding 

comments. 

'Christine E. Blair is a financial economist 

in the FDIC's Division of Research and Statis 

tics. 

The issues concerning the separation of 

banking and commerce have been widely dis 

cussed. See, t&, FDIC (1987), Huertas (1986) 

and Couigan (1987, 1991). 
Banking and Commerce 

An Historical Overview of 

Bank Powers 

This section traces the evolution of 

the definition of bank powers from 

grants of specific powers in the early 

bank charters to a generally applica 

ble, broadly defined legal definition. 

An examination of what constituted 

banking in practice shows that this 

definition has evolved considerably, 

Early Chartered Banking 

(1781-1838) 

Early bank charters granted by 

state legislatures provided a general 

right to incorporate and engage in 

banking.2 However, they generally 

did not articulate what constituted 

the business of banking. The mixing 

of banking with some form of com 

merce often occurred. This period of 

early American economic develop 

ment was characterized by a rapid ex 

pansion of business and the 

concurrent need for credit. As a result, 

corporations chartered to engage in 

some particular line of commerce,^,, 

agricultural, industrial or publicworks interests, also were given the 

authority to engage in a general bank 

ing business.3 

For example, the precursor to the 

Chase Manhattan Bank was chartered 

in 1799 as the Bank of the Manhattan 

Company to develop a water system 

for New York City. The charter also 

permitted the directors of the water 

company to use surplus capital in any 

way they thought expedient or 

proper, including the business of 

banking. The company subsequently 

engaged in banking and life insurance 

businesses, and, incidentally, oper 

ated the water business throughout 

the 19th century.4 Similarly, what is 

now Chemical Bank was chartered by 

the State of New York in 1823 as the 

New York Chemical Manufacturing 

Co. Under its original charter, Chem 

ical was permitted to manufacture 

chemicals and, by an 1824 amend 

ment, to engage in a general banking 

business. The practice of combining 

banking and commercial activities 

was common during the "early char 

tered bank" period, that ran roughly 

from the chartering in 1781 of the 

Bank of North America to the passage 

of the New York Free Banking Act of 

1838. 

As the states began to grant bank 

charters more freely, they also began 

to limit the nature of the banking 

business authorized by the charter. As 

the bank charter changed from a gen 

eral to a more specific grant of power, 

a more well-defined but limited defi 

nition of the business of banking re 

sulted. This change reflected the 

recognition by the states that banks 

"should be provided powers that en 

abled them to assist in the functioning 

of the economy and in serving enter 

prise, but stopped [them] from be 

coming so involved in enterprise that 

they could be destroyed by it."6 This 

change also marked the movement 

toward the so-called "free-banking" 

period in American banking history. 

Free-Banking: The New York 

Free Banking Act of 1838 

Bank charters enumerated the 

powers available to banks as early as 

1825. One of the earliest definitions 

of the "business of banking" ap 

peared that year in the charter of the 

Commercial Bank of Albany. The 

bank was authorized 

". . . to carry on the business of 

banking by discounting bills, notes 

and other evidences of debt; by 

receiving deposits; by buying gold 

and silver bullion and foreign coins; 

by buying and selling bills of 

exchange, and by issuing bills, notes, 

and other evidences of debt"; and 

granted "no other powers whatever."7 

This early definition formed the basis 

for the definitions of banking that 

subsequently were adopted at the 

state and federal levels. 

In 1838, the State of New York 

extended the "privilege" of banking 

to the general public, through the pas 

sage of the New York Free Banking 

Act,6 The 1838 Act's "powers 

clause," similar to that found in the 

Commercial Bank of Albany's 1825 

charter, enumerated the powers avail 

able to banks, including the right to 

engage in the "business of banking" 

Importantly, the 1838 Act marked 

". .. the evolution of laws from indi 

vidual and specific enactments into 

general statutes of uniform and com 

prehensive nature."9 As a result, this 

Act fundamentally changed the na 

ture of banking. 

The powers clause did not restrict 

or expand banking powers ". . , but 

rather [articulated] the consensus that 

what banks were already doing was 

permissible and should be contin 

ued."10 While not engaging in mer 

cantile or general investment 

activities, banks were engaged in ex 

tending both short- and long-term 

credit, and providing investment 

banking services. The credit needs of 

business and government were pro 

vided by direct extensions of credit, 

primarily in the form of long-term 

loans or accommodation paper, and 

the purchase of debt obligations. 

Commercial banks were the original 

investment bankers in America, pro 

viding "loan contracting" services be 

fore a market in the resale of securities 

developed. They continued to be 

major providers of investment bank 

ing services throughout the freebanking era. 

The charter was the standard method of 

incorporation for all businesses, including 

banking. Charters conveyed limited liability, 

monopoly privilege and honorific legal status. 

(Hammond (1936), p. 186.) 

3S«? FD1C (1987), pp. 23^1; and Symons 

(1983), pp. 686-87. 

4Hammond, (1957), pp. 155-57. 

SMoodys(1928>. 

6Symons(1983),p. 689. 

'Hammond (1957), p. 593, citing John 

Cleaveland, The Banking System of the Slate of 

New York (New York, 1857), pp. xvi, xxvii. 0 

Under free-banking, all individuals willing 

and able to meet minimum capital and regula 

tory standards set by the state could obtain a 

bank charter. In return for charters, bankers 

posted collateral for the notes they issued to the 

public. State bonds were used as collateral, on 

the premise that they could be sold to reim 

burse noteholders in the event of a bank failure. 

Free-banking was practiced in many states dut

ing the 19th century, although not always suc 

cessfully. In New York, however, the move to 

free-banking proved successful. 

9Hammond(1957), p. 593. 

IDSymons (1983), pp. 691, 697-98. 

29 
FDIC Banking Review 

The National Bank Act 

ofl864 

The National Bank Act of 1864 

nationalized free-banking.11 Section 

Eight of the National Bank Act enu 

merated the powers granted to na 

tional banks, essentially adopting the 

powers clause from the 1838 New 

York Free Banking Act. Among these 

powers, banks may exercise 

"... all such incidental powers as shall 

be necessary to carry on the business of 

banking by discounting and 

negotiating promissory notes, drafts, 

bills of exchange, and other evidences 

of debt; by receiving deposits; by 

buying and selling exchange, coin, and 

bullion; by loaning money on personal 

security; by obtaining, issuing, and 

circulating notes according to 

provisions of this act."12 

Since its inception, the National 

Bank Act's powers clause has been 

subject to debate and interpretation. 

However, changes in bank powers 

that occurred from 1864 until the pas 

sage of the Glass-Steagall Act in 1933 

largely were the result of specific lim 

itations or specific grants and not a 

redefinition of general powers. 

During the period of "nationalized 

free-banking," national banks could 

engage in securities activities in addi 

tion to their general banking activi 

ties. In addition to deposit-taking and 

note issuance, general banking in 

cluded short- and long-term lending 

for commercial, agricultural, and realestate purposes. Banks also held call 

loans, commercial paper, and govern 

ment and corporate securities in their 

portfolios. Banks' role in investment 

banking included securities under 

writing and distribution, and syndi 

cate management. Banks formed 

partnerships in underwriting syndi 

cates as well as in-house investment 

banking departments, many of which 

were turned subsequently into secu 

rities affiliates. 

National banks were subject to ac 

tivity restrictions as well. For exam 

ple, during this period, national banks 

could not engage in trust or safe de 

posit businesses.13 The National 

Bank Act atso imposed a number of 

safety-and-soundness regulations. 

Among these, national banks were 

prohibited from lending on real es 

tate, lending limits to any one bor 

rower were established, minimum 

reserves on deposits were imposed, 

and limits were placed on borrowing 

in excess of the bank's capital stock.14 

However, the effectiveness of these 

regulations was questionable.15 

The presumption following the 

passage of the National Bank Act had 

been that state-chartered banks 

would convert to national charters. In 

centives had been created to encour 

age conversion, including a tax on 

note issues of state-chartered banks. 

However, by 1913, state-chartered 

banks outnumbered national banks 

by more than two to one. While na 

tional charters generally conferred 

greater prestige as well as a competi 

tive edge in terms of note issuance, 

state charters generally required 

lower capital and lower reserves while 

permitting a wider range of activities, 

including real-estate lending and 

trusts.16 

The Movement Toward 

Comprehensive Finance 

The free-banking era was charac 

terized by a movement toward "de 

partment store" or comprehensive 

finance during the last quarter of the 

19th century and the first decades of 

the 20th century. Commercial banks 

competed with trust and other finan 

cial-services companies to provide 

customers with a range of financial 

services including deposits, credit, fi 

duciary, investment and insurance 

services. 

Trust Company Activities. Trust 

companies were chartered as early as 

1822; empowered to execute lawful 

trusts, they could not issue bank 

notes. By the late 1880s, trust compa 

nies had expanded the range of finan 

cial services offered: accepting 

checkable, interest-bearing deposits; 

lending on collateral such as merchan 

dise, stocks and bonds, and real estate; 

and providing investment banking 

services. With the exception of their 

fiduciary role and their inability to 

issue circulating notes, trusts became 

virtually indistinguishable from 

banks.17 Similarly, the safe deposit 

business developed as an adjunct to 

the trust business. For the better part 

of the free-banking era, national 

banks were prohibited from engaging 

in this business as well.18 

nThe National Bank Act of 1864 was de 

signed by ihe Congress to achieve several ob 

jectives, including the establishment of a 

national currency and the creation of a market 

for federal bonds to meet the financing needs 

of the federal government. As well, it marked 

the beginning of the American system of "dual 

banking." Dual banking refers ro the concur 

rent state and federal chartering and regulation 

of banks. It remains an important political and 

economic force in the American banking sys 

tem today. 

12National Bank Act of June 3, 1864, cited 

bySymons(1983),p. 700. 

Only the states chartered banks with trust 

powers before 1913. In that year, the Federal 

Reserve Act authorized national banks to offer 

certain limited trust services for corporations. 

By 1918, national banks could apply for a full 

range of trust activities. 

In addition to activity restrictions imposed 

by the states or the National Bank Act, a system 

of supervision developed in the late 1800s. 

State banking departments were formed and 

regular examinations were instituted for both 

state-chartered and national banks. The Fed 

eral Reserve Act of 1913 further formalized a 

system of national bank examination. (Kleba

ner (1990), pp. 99-101.) 

L5Klebaner notes that one-third of all na 

tional banks managed to violate the provisions 

of the law. At the end of the 19th century, 25 

percent were deficient in reserves, 17 percent 

lent on real estate and ten percent made loans 

in excess of the legal limit for one borrower. For 

example, when faced with competition from 

state-chartered banks in the case of real-estate 

lending, banks found ways to circumvent the 

restrictions, with the approval of the Comptrol 

ler of the Currency. (Klebaner(1990),p. 101.) 

16Klebaner(1990),p.69. 

1 Trusts "took advantage of the ambiguities 

surrounding the proper boundaries of bank 

ing." In doing so, they became formidable 

competitors of banks. For example, in 1875, 

New York City had nine trust companies with 

12 percent of commercial banking assets; by 

1900 there were 31 companies holding 32 per 

cent of these assets. (Klebaner (1990), p. 72.) 

1 Safe deposit companies often affiliated 

themselves with trust companies and, indi 

rectly, with banks. Chartered in 1861, the Safe 

Deposit Company of New York was the firsc 

corporation dedicated totally to receiving prop 

erty for safe-keeping. National banks were pro 

hibited from engaging in this business by an 

1867 Comptroller of the Currency ruling. This 

prohibition was repealed by the 1927 

McFaddcn Act. (Klcbaner (1990), pp. 73-4.) 

30 
Banking and Commerce 

National banks formed alliances 

with trust companies, whereby each 

would refer trust and banking busi 

ness to the other. In 1903, several 

commercial banks organized the 

Bankers Trust Company as a fiduciary 

firm that would act as a trust company 

for, and not in competition with, na 

tional and state banks. The Federal 

Reserve Act of 1913 authorized na 

tional banks to offer limited trust ser 

vices for corporations. A full range of 

trust activities was available to na 

tional banks by 1918. By 1928, the 

Bankers Trust Company had banking, 

bond, foreign and trust departments; 

the bond department engaged in the 

underwriting and distribution of secu 

rities. 

Bank Affiliates. By the late 

1920s, banks were involved fully in 

comprehensive finance. Through af 

filiate relationships, banks were able 

to offer a full range of financial ser 

vices that included investment bank 

ing, trust and safe deposit, savings, 

insurance and mortgage products.19 

In order to better compete as pro 

viders of comprehensive finance, na 

tional banks moved their investment 

banking business our of their bond 

departments and into newly organ 

ized securities affiliates. These were 

chartered under the general business 

incorporation laws of the states, and 

were owned and controlled by the 

stockholders of the national banks. 

Affiliate relationships also were estab 

lished between banks and realty com 

panies, safe deposit companies, 

mortgage companies and insurance 

agencies during this period. 

Affiliate control by the bank's 

stockholders often was established 

through common ownership of the 

controlling stock in both the bank and 

its affiliates. For example, Chase Se 

curities Corp. was incorporated in 

May 1917 under the business incor 

poration law of the State of New York. 

Organized by Chase Manhattan 

Bank, Chase Securities Corp. was 

capitalized out of undivided profits of 

the bank and, therefore, the bank's 

stockholders had apro rata interest in 

the affiliate.20 

The securities affiliates were not 

restricted by the limitations of the Na 

tional Bank Act, in particular the pow 

ers clause. Therefore, they had 

virtually unlimited authority to en 

gage in activities that were prohibited 

to banks. Moreover, the affiliates 

were not subject to any examination. 

Many abuses arose in the affiliate 

system. The abuses connected with 

the operation of securities affiliates by 

commercial banks during the 1920s 

fell into three general categories: 

those abuses that were common to 

investment banking generally; those 

abuses that resulted from self-dealing 

by bank officers and directors; and 

those abuses related to the mixing of 

commercial and investment bank

ing-21 

For example, underwriting and 

distributing unsound and speculative 

securities, conveying untruthful or 

misleading information in the pros 

pectuses accompanying new issues, 

and manipulating the market for cer 

tain stocks and bonds during issuance 

were abuses that occurred within the 

entire investment banking industry 

during the 1920s and 1930s. These 

abuses were not exclusive to commer 

cial banks and their securities affili 

ates. 

An example of self-dealing by 

bank officers and directors was the 

use of investment pools to manipulate 

the stock prices of the parent bank. 

Organized by the securities affiliates, 

the investment pools or trading ac 

counts generally were open only to 

the bank officers and directors who, in 

turn, stood to benefit from trading on 

their insider information. In addition 

to receiving large profits from such 

trading, bank officers and directors 

often received compensation through 

affiliates that was far in excess of that 

paid to them by their banks. 

Finally, the abuses that arose from 

the mixing of commercial and invest 

ment banking can be characterized 

generally as conflicts of interest. Such 

situations included: the use of the se 

curities affiliate as a dumping ground 

for bad bank loans; the use of the bank 

or its trust department as a receptacle 

for securities that the affiliate could 

not sell; and the use of bank loans to 

finance the purchase of securities un 

derwritten by the securities affiliate. 

These and other abuses contributed 

to the public's outrage against com 

mercial banks and their securities af 

filiates. Whether these abuses 

warranted the subsequent separation 

of commercial and investment bank 

ing under Glass-Steagall has been de 

bated ever since.22 

The McFadden Act The Con 

gress addressed national bank partici 

pation in investment banking in the 

1927 McFadden Act. This Act reaf 

firmed the right of national banks to 

engage directly in underwriting secu 

rities and gave the Comptroller of the 

Currency the right to determine 

which securities could be underwrit 

ten directly by the bank and which 

must be underwritten by the securi 

ties affiliates. Together, banks and 

their securities affiliates engaged in 

the business of investment banking to 

an extent on par with the private in 

vestment banking houses.23 The 

McFadden Act also granted national 

banks increased powers to engage in 

the safe deposit business, make realestate loans, open branches and lend 

a larger amount than previously to one 

borrower.24 

New Deal Legislation. The high 

lights of the "Great Crash" are wellknown: the stock-market crash, the 

collapse of the banking system and the 

Great Depression. For the most 

part, banks were held accountable 

for these problems. In particular, 

abuses of the operations of commer 

cial banks' securities affiliates were 

alleged to be the primary cause of 

For exampJe, in 1903, the First National 

Bank of Chicago's bond department, unable to 

deal in bonds secured by mortgages on real 

estate, moved that function to a newly organ 

ized affiliate, the state-chartered First Trust 

and Savings Bank. (Klebaner (1990), p. 91.) 

20Moodys(1928). 

2IFDIC (1987), pp. 39-44. 

2ZSee, e.g., FDIC (1987), and Benston 

(1990). 

3Peach(1941), p. 20. 

, pp. 127, 135. 

31 
FDIC Banking Review 

these events.25 In dealing with the 

abuses of the banks and their securi 

ties affiliates, Congress chose to elim 

inate the role of the securities 

affiliates, effectively limiting the role 

Df national banks to that of commer 

cial bankers. 

Congress debated, but declined 

to adopt, an alternate approach that 

would have utilized a system of ex 

amination and regulation to control 

the potential for abuse in the affili 

ate system. As noted by Peach 

(1941), certain dangers arising from 

affiliate relationships cannot be 

avoided by legislation and regula 

tion alone. For example, the com 

mingling of names within a banking 

organization potentially ties the 

goodwill of the parent to that of the 

affiliate. These issues currently face 

banking organizations and their reg 

ulators as they move into the retail 

ing of financial-services products 

such as mutual funds and insurance. 

Through the New Deal legislation 

passed by the Congress, reforms were 

introduced to restrict the activities of 

banks and their affiliates, and the 

financial-services industry was seg 

mented.26 Notably, a partial segmen 

tation of commercial and investment 

banking was achieved through the 

"Glass-SteagaH" sections of the Bank 

ing Act of 1933.27 The firewalls found 

in the Glass-Steagall Act and subse 

quent legislation are discussed in the 

following section. 

Current Restrictions on 

Nonbank Activities of 

Commercial Banks 

Current restrictions on the nonbank activities of commercial banks 

can be traced to the Banking Act of 

1933, which instituted, along with the 

federal deposit insurance system, the 

separation of commercial banking 

from certain investment banking ac 

tivities. Generally, limitations on 

banks' activities and affiliations have 

been the focus of these firewalls. list 

of contemporary firewalls includes, 

but is not limited to, the GlassSteagall Act, Sections 23A and 23B 

amendments to the Federal Reserve 

Act, and the Bank Holding Company 

Act of 1956 and its amendments. As 

well, recent legislative changes and 

rules and regulations, such as FRB 

rulings and Office of the Comptroller 

of the Currency (OCC) interpretive 

letters, have contributed to what con 

stitutes a framework for establishing 

the legal and economic separation of 

banking from other activities.28 

The Glass-Steagall Act. Sections 

16, 21, 20 and 32 of the Banking Act of 

1933 constitute what is commonly re 

ferred to as the Glass-Steagall Act. 

Under Glass-Steagall, the ability of 

commercial banks to engage directly in 

securities activities and to affiliate with 

organizations that engage in securities 

activities is restricted. 

Sections 16 and 21 restrict the se 

curities activities of commercial 

banks. Section 16 generally prohibits 

commercial banks from purchasing 

securities for their own account. Spe 

cifically, it provides that the "business 

of dealing in securities and stock by 

the association shall be limited to pur 

chasing and selling such securities 

and stock without recourse, solely 

upon order, and for the account of 

customers, and in no case for its own 

account, and the association shall not 

underwrite any issue of securities or 

stock . . ." The provision applies to 

both national banks and state-char 

tered banks that are members of the 

Federal Reserve System (member 

banks). However, Section 16 permits 

a national bank to purchase invest 

ment securities for its own account 

under such limitations and restric 

tions as prescribed by regulation by 

the Comptroller of the Currency.29 

Section 21 prohibits persons or or 

ganizations engaging in securities ac 

tivities from accepting deposits; the 

effect is to extend the Section 16 secu 

rities prohibition to state-chartered 

banks that are not members of the 

Federal Reserve System (nonmember 

banks).30 Specifically, Section 21 pro 

hibits any "person, firm, corporation, 

association, business trust or other sim 

ilar organization, engaged in the busi 

ness of issuing, underwriting, selling, 

or distributing, at wholesale or retail, or 

through syndicate participation, stocks, 

bonds, debentures, notes, or other securi 

ties, to engage at the same time to any 

extent whatever in the business of re 

ceiving deposits." Exceptions to the prohi 

bitions of Sections 16 and 21 on the direct 

securities operations of commercial banks 

are made for obligations of the United 

States, obligations issued by government 

agencies, college and university dormi 

tory bonds, and the general obligations 

of states and political subdivisions.31 

"The 1933 and 1934 Stock Exchange Prac 

tices Hearings of the Senate Committee on 

Banking and Currency, referred to as the 

"Pecora Hearings," examined the abuses relat 

ing to commercial banks' securities affiliates 

and operations. See, e.g., Peach (1941), FDIC 

(1987) and Bension (1990) for further discus 

sion of the abuses and their importance. 

Limits on bank powers, price and geographic 

restrictions were established. These included 

limits on branching, "needs" tests as criteria for 

obtaining new charters, and prohibitions on the 

offering of transaction accounts by any but com 

mercial banks. Price competition among banks 

was restricted through the establishment of inter 

est-rate ceilings, and asset-quality competition 

was made largely irrelevant by deposit insurance. 

This Act also created the Federal Deposit 

Insurance Corporation. Other legislation cre 

ated the Securities and Exchange Commission 

to oversee the securities industry; the Federal 

Reserve Board, as the nation's central bank, was 

granted additional powers, such as the power to 

vary reserve requirements. 

T'he interested reader is referred to the 

"Statutory and Regulatory Safeguards" appendix 

of the FDIC's Report to Congress on the Findings 

and Recommendations Concerning the "Two-Win 

dow" Deposit System Proposal(September 1992). 

This appendix provides a general description 

{i.e., definition and function) of many of the 

firewalls mentioned in this section. 

z<>See Benston (1990), p. 8. Commercial 

banks' authority under Section 16 to purchase and 

sell securities directly has been interpreted by the 

courts and the regulatory authorities. For example, 

through OCC Interpretive Letters, banks have 

been permitted to purchase and sell mutual shares 

for chcir customers as their agent and sell units in 

unit investment trusts, as well as offer, riirough a 

subsidiary, brokerage services and investment 

advice as well as discount brokerage services, 

30However, it does not prohibit subsidiaries 

or affiliates of insured nonmember banks from 

engaging in securities activities. See the dis 

cussion on Section 20 affiliates. 

31Municipal revenue bonds are not included 

in the list of exceptions, although they are of 

greater importance in financing municipalities 

today than general obligations. Note also, that a 

1985 Federal Reserve Board decision allows 

commercial banks to act as advisers and agents 

in the private placement of commercial paper. 

(Sft? Benston (1990), p. 7.) 

32 
Banking and Commerce 

Section 20 prohibits national and 

state member banks from affiliating 

with organizations that are "engaged 

principally in the issue, flotation, un 

derwriting, public sale, or distribution 

at wholesale or retail or through syn 

dicate participation of stocks, bonds, 

debentures, notes or other securi 

ties." The intent of this prohibition is 

to prevent commercial banks from en 

gaging in securities activities indi 

rectly through affiliates. The 

applicability of this Section hinges on 

the term, "engaged principally." 

Since 1987, bank holding companies 

have been permitted on a case-by

case basis to affiliate with so-called 

Section 20 corporations that engage to 

a limited extent, i.e., are not "engaged 

principally," in securities activities. 

Section 20 affiliates are discussed in 

more detail below. 

Finally, Section 32 prohibits any 

officer, director, employee or partner 

of any organization engaged primarily 

in the underwriting of securities, or 

any individual so engaged, from serv 

ing simultaneously as an officer, direc 

tor, or employee of any national or 

member bank, subject to limited ex 

ceptions as may be permitted by the 

FRB. The intent is to preclude con 

flicts of interest that may arise from 

director, officer or employee inter 

locks between banks and any persons 

or organizations primarily engaged in 

the securities business. 

Insured nonmember banks are not 

subject to the restrictions of Sections 

20 and 32. The FDIC's 1982 ruling 

that Glass-Steagall does not apply to 

the securities activities of subsidiaries 

of insured nonmember banks was 

challenged in the courts and upheld.32 

As a result, insured nonmember 

banks are permitted to affiliate with 

securities firms.33 

The separation of commercial 

from investment banking is not com 

plete. For example, Glass-Steagall 

does not prohibit commercial banks 

from underwriting and dealing in cor 

porate securities overseas. GlassSteagall, as amended and interpreted 

by the bank regulatory agencies and 

the courts, often on a case-by-case 

basis, allows commercial banks to en 

gage in some securities activities, 

both directly and through affiliates. 

As examples, commercial banks may 

aid in the private placement of corpo 

rate securities; underwrite and deal in 

general obligation municipal securi 

ties as well as certain types of munic 

ipal revenue bonds; engage in trust 

activities, mutual fund activities, and 

asset securitization; and provide bro 

kerage and investment advisory ser 

vices,34 The firewalls that constitute 

Glass-Steagall limit some securities ac 

tivities, but certainly are not sufficient, 

nor were they intended to be sufficient, 

to establish a complete separation of 

commercial from investment banking. 

Sections 23A and 23B of the 

Federal Reserve Act. Additional 

firewalls affecting the activities of 

banks and their nonbank affiliates 

were created through amendments to 

the Federal Reserve Act, notably Sec 

tions 23A and 23B. Section 23A of the 

Federal Reserve Act was enacted as 

part of the Banking Act of 1933, while 

Section 23B of the Federal Reserve 

Act was created by the Competitive 

Equality Banking Act of 1987 

(CEBA). By placing general quantita 

tive and qualitative restrictions 

against transactions that banks may 

enter into with their banking and nonbanking affiliates, these amendments 

are intended to function as a primary 

safeguard against risks to the bank 

and, in turn, the deposit insurance 

funds, 

Section 23A addresses the poten 

tial conflicts of interest that may arise 

between closely related entities and 

the possible misuse of bank financial 

resources for the benefit of these affil 

iates.35 Such conflicts arise when an 

insured bank incurs or makes loans, 

guarantees or other obligations, and 

such transactions threaten the sol 

vency or soundness of the bank.36 In 

particular, Section 23A provides that, 

in the case of any one affiliate, the 

aggregate amount of the "covered 

transactions" between the bank and 

that affiliate is limited to ten percent 

of the capital stock and surplus of the 

bank.37 The limit on covered transac 

tions between the bank and all affili 

ates in the aggregate is 20 percent of 

the bank's capital and surplus. These 

proscriptions also extend to individu 

als transacting on behalf of the affili 

ate. In addition, most extensions of 

credit or guarantees involving a nonbank affiliate must be fully collateral

ized; the sale of subquality assets to 

the bank is prohibited; and transac 

tions with affiliates must be on terms 

and conditions that are consistent 

with safe-and-sound banking prac 

tices.38 

Section 23A was revised under the 

Banking Affiliates Act of 1982.39 The 

term "affiliate" was redefined to be 

less restrictive, so that the movement 

of funds between banks and certain 

entities that were deemed to be less 

likely to result in unsafe or unsound 

banking practices could be facilitated. 

Under Section 23A, the term affiliate 

refers to ". , . those [entities] so 

closely related or connected to the 

member bank that transactions be 

tween the bank and the affiliate would 

Investment Company Institute v. FDIC, 815 

F2d 1540, cert, denied, 108 S. Ct 143 (1987). 

Under the FDIC's regulations, insured 

nonmember banks may establish "bona fide" 

subsidiaries that underwrite investment quality 

equity and other securities. The FDIC's regu 

lation defines a "bona fide" subsidiary as a 

subsidiary that is physically separate and dis 

tinct in its operations from the bank, shares no 

common officers, and satisfies other require 

ments designed to ensure its separation from 

the bank. (12 C.F.R. Sec337.4(a)(2)). 

USee Benston (1990), pp. 6-10. 

Affiliates, as defined under Section 23A, 

are discussed below. Miles (1988), footnote 25, 

provides a detailed definition of Section 23A 

affiliates. 

J6FDIC(1987),p. 87. 

A "covered transaction" is one in which an 

affiliate, as denned under Section 23A, receives 

funding or financing from a member bank. For 

example, loans to, and guarantees or purchases of 

the obligations of nonbank affiliates by the bank 

are covered transactions. See Miles (1988), foot 

note 35, for a listing of such covered transactions 

undeT Section 23A. 

3BFDIC(1987), p. 88. 

3 The Banking Affiliates Act of 1982 is part 

of the Garn-St Germain Depository Institutions 

Act of 1982. 
FDIC Banking Review 

not be at arm's length."40 Originally, 

23A affiliates included the parent 

holding company of a member bank, 

other subsidiaries of the holding 

company, and any company inter 

locked with the member bank 

through shareholders or directors or 

indirectly through a trustee relation 

ship. This definition included sister 

banks. The revised definition ex 

empted sister banks and certain 

nonbank subsidiaries of member 

banks from the definition of affiliate 

for the purposes of Section 23A. The 

rationale for these exemptions is as 

follows. Sister banks are subject to 

the same type of regulatory and ex 

amination processes, which is be 

lieved to reduce the threat of unsafe 

and unsound banking practices. 

Similarly, to the extent that certain 

nonbank subsidiaries are subject to 

banking agency supervision and reg 

ulation, 23A restrictions are deemed 

unnecessary. 

The Section 23A revisions also 

provided that 23A restrictions may be 

applied as deemed appropriate by the 

FRB, e.g., the subsidiaries of member 

banks in which the member bank 

does not hold a controlling interest. 

The definition of affiliate was ex 

panded to include entities with inter 

locks to the parent holding company. 

Organizations sponsored and organ 

ized by a bank, such as Real Estate 

Investment Trusts (REITS), also are 

defined to be affiliates of the bank.41 

Section 23Aalso has been the focus 

of reform proposals whose primary in 

tention was the repeal of the GlassSteagall restrictions on the securities 

activities of banks and their affiliates. 

Regulators and legislators have 

sought to offset any adverse safety

and-soundness implications of GlassSteagall reform by reinforcing the 

firewalls present in Section 23A. By 

strengthening the capacity of Section 

23A to insulate and protect the in 

sured bank, it is argued, the rationale 

for maintaining the Glass-Steagall bar 

riers between commercial and invest 

ment banking would be weakened. 

For example, in 1983 and 1984, 

legislative proposals to expand the 

range of permissible bank activities 

would have required the repeal of 

some Glass-Steagall prohibitions.42 In 

each case, a supplement to Section 

23A was proposed that would have 

expanded Section 23A restrictions to 

the proposed new activities. The pur 

pose of the supplemental restrictions 

was to provide the Federal Reserve 

with greater flexibility to control po 

tential conflicts of interest that might 

arise from such transactions between 

the bank and its affiliates. That is, an 

expansion of the "firewalls" of Sec 

tion 23A was sought in tandem with 

any expansion of bank powers. 

In 1987, CEBA supplemented the 

list of firewalls through a new amend 

ment to the Federal Reserve Act, Sec 

tion 23B. Section 23B defines the 

terms and conditions under which a 

bank and its covered affiliates (affili 

ates as defined under Section 23A) 

may enter into certain transactions. 

Those transactions must be carried 

out on terms and conditions that are 

substantially the same as those pre 

vailing at the time for comparable 

transactions with nonaffiliated com 

panies, i.e., at "arm's length." The 

purpose is to ensure that a bank does 

not subsidize its covered affiliates 

through preferred treatment on loans 

or other contracts with the bank. In 

this way, Section 23B seeks to main 

tain banks' role as a neutral allocator 

of credit in the intermediation pro 

cess. 

Section 23B generally prohibits 

bank trust departments from purchas 

ing securities of an affiliate and places 

severe restrictions on the acquisition 

of securities by the bank during the 

time any affiliate is acting as an under 

writer or member of a selling syndi 

cate of such securities. As well, 

prohibitions are placed on actions by 

a bank or its covered affiliate that 

would suggest that the bank is respon 

sible for any obligation of the affiliate. 

The following transactions are in 

cluded under Section 23B: (1) the sale 

of securities or other assets to an affil 

iate, including those subject to an 

agreement to repurchase; (2) the pay 

ment of money or the furnishing of 

services to an affiliate under contract, 

lease, or otherwise; (3) any transaction 

in which an affiliate acts as an agent or 

broker or receives a fee for its services 

to the bank or to any other person; and 

(4) any transaction or series of transac 

tions with a third party if an affiliate 

had a financial interest in the third 

party or if an affiliate is a participant 

in such transaction or series of trans 

actions.43 

The Bank Holding Company 

Act of 1956. The Banking Act of 

1933 first defined bank holding com 

panies and established the framework 

for their regulation. However, the re 

strictions on ownership and affiliation 

are the product of the Bank Holding 

Company Act of 1956 (BHCA) and its 

subsequent 1966 and 1970 Amend 

ments. The basis for the expansion of 

bank holding company regulations 

was the belief that it was necessary to 

prevent the monopolization of bank 

ing by holding companies and the for 

mation of large banking-industrial 

complexes. With the passage of the 

1970 Amendments, virtually all bank 

holding companies became subject to 

federal regulation, and statutory and 

regulatory controls were placed on the 

expansion of bank holding companies 

into other businesses.44 That is, a 

separation of banking from commerce 

was established in terms of restric

wMiles(1988),p.485. 

Other amendments adjusted the defini 

tion of "covered transaction" and expanded the 

range of quantitative limits so as to close a 

loophole through which non-affiliates could act 

as a conduit for transfers of unlimited funds 

between the banks and affiliates. Adjustments 

also were made to the list of acceptable collat 

eral. &r Miles (1988). 

42Senate bills S. 1609 and S. 2851 proposed 

an expansion of bank services to include such 

activities as insurance underwriting and broker 

age, real-estate development and certain secu 

rities activities. Both bills also proposed 

amendingthe Federal Reserve Act to include a 

new Section 23B, chat would have supple 

mented Section 23A by further restricting 

transactions between banks and theiraffiliates. 

43Miles (1988), p. 478, footnote 4. 

An exemption from federal regulation for 

one-bank holding companies had been pro 

vided by the Banking Act of 1935; this exemp 

tion was removed by the 1970 Amendments. 

34 
Banking and Commerce 

lions on the activities of the owners 

and affiliates of banks. 

Under the BHCA of 1956, a bank 

holding company was defined as a 

corporation owning at least a 25 per 

cent interest in two or more commer 

cial banks, whether Federal Reserve 

members or not. FRB approval was 

required for the creation or expansion 

of bank holding companies; interstate 

acquisitions of banks were limited, 

and the right of states to limit bank 

holding company expansion was up 

held. Ownership of shares in nonbank 

corporations, other than those of cor 

porations engaged in approved bankrelated activities, was prohibited. The 

1956 Act also prohibited a bank hold 

ing company or its nonbank subsid 

iary from engaging in any nonbanking 

activity, except as otherwise provided 

in the BHCA. Multibank holding 

companies were allowed to engage in 

certain activities.45 The FRB was 

given the authority to allow additional 

nonbanking activities other than 

those expressly permitted if they 

could be shown to be "of a financial, 

fiduciary, or insurance nature" and 

were "so closely related to the busi 

ness of banking or managing or con 

trolling banks as to be a proper 

incident thereto." The list of activi 

ties approved by the FRB under this 

statute subsequently became known 

as "the laundry list." 

The Bank Holding Company 

Act Amendments. The BHCA was 

amended in 1966 and 1970. The 1966 

Amendments primarily addressed 

problems in the 1956 Act. Standards 

for the evaluation of holding company 

applications were revised and exemp 

tions from the BHCA provisions for 

investment companies and their affil 

iates, religious, charitable and educa 

tional institutions were eliminated.46 

The 1966 Amendments also relaxed 

the 1956 Act by applying Section 23A 

of the Federal Reserve Ace to transac 

tions between the parent holding 

company and its subsidiary banks and 

between sister subsidiary banks; the 

1956 Act had prohibited virtually all 

normal banking transactions between 

these entities. 

The 1970 Amendments were fo 

cused on the regulation of one-bank 

holding companies and the nonbank 

activities of bank holding companies. 

The rapid growth in the number and 

size of one-bank holding companies 

during the 1960s raised concern 

among bank regulators and led to de 

mands from the Congress and inde 

pendent banks for the inclusion of 

one-bank holding companies under 

the BHCA, The 1970 Amendments 

accordingly extended regulation 

under the BHCA to one-bank holding 

companies. As a result, FRB oversight 

was extended to virtually all bank 

holding companies. 

The 1970 Amendments also re 

vised the standards that defined per 

missible nonbank activities. Under 

Section 4(c)(8), the FRB, through the 

use of regulation, interpretation, or 

individual decisions, has ruled on the 

permissibility of numerous nonbank 

activities.47 A bank holding company 

or its nonbank subsidiary may engage 

in a nonbanking activity, including a 

securities activity, only if (1) the activ 

ity is "closely related to banking" and 

(2) the provision of the activity would 

likely result in public benefits that 

outweigh possible adverse effects, 

The FRB also was given authority to 

differendate between applications to 

engage in an activity through a de novo 

subsidiary or acquisition of an existing 

firm. Anci-cying provisions that pro 

hibit a banking company from tying 

an extension of credit or any other 

bank service to the use of the services 

of nonbank subsidiaries of the hold 

ing company were incorporated 

through Section 106 of the BHCA 

under the 1970 Amendments. 

Most of the nonbanking activities 

that have been approved by the FRB 

for bank holding companies under 

Section 4(c)(8) also have been permit 

ted for national banks as "incidental 

to banking" under the Office of the 

Comptroller of the Currency's Inter 

pretive Letters. In recent years the 

FRB has issued a large number of 

Section 4(c)(8) decisions, most of 

which relate to investment and mer 

chant banking activities.48 As a result, 

the original intent of Glass-Steagall to 

separate commercial from investment 

banking has been eroded. Relative to 

how it was interpreted in the early 

1980s, the separation is much less 

stringently enforced today. 

Section 20 Affiliates. In 1987, 

the FRB approved several so-called 

"Section 20" applications that would 

permit bank holding companies to es 

tablish nonbank subsidiaries to un 

derwrite and deal in certain types of 

securities, including municipal reve 

nue bonds, mortgage-related securi 

ties, commercial paper and 

consumer-related receivables.49 The 

FRB's approval was based on the 

affiliate's not being "engaged princi 

pally" in that particular underwriting 

activity, as proscribed by Section 20 of 

the Glass-Steagall Act.50 

Activities included awning and managing 

bank holding company property, providing ser 

vices to subsidiary banks, operating a safe de 

posit company, and liquidating property acquired 

by subsidiary banks. (Board of Governors (1978), 

p. 46.) 

See Board of Governors (1978). For exam 

ple, the elimination of this exemption brought 

the Alfred I. Du Pont Estate, which controlled 

30 banks and many nonbank companies, under 

the BHCA regulation. 

Nonbank activities determined by FRB 

regulation to be "closely related" to banking, 

and therefore permissible nonbank activities 

for bank holding companies, are listed under 

Regulation Y. Other nonbank activities have 

been approved by individual order, i.e., FRB 

approval of individual applications on case-by

case basis. For example. Section 20 affiliates 

are approved in this manner. 

Holland (1991) lists permissible activities 

under Section 4(c)(8) of the BHCA. The ap 

pendix to Benston (1990) provides a list of se 

curities activities of banking organizations 

permitted under federal law. Updates on re 

cent regulatory agency actions concerning bank 

powers and permissible nonbanking activities 

can be found in Benjamin B. Christopher's 

"Recent Developments Affecting Depository 

Institutions," which is a regular feature con 

tained in the FDIC Banking Review. 

49On April 30, 1987, the FRB approved the 

applications of Citicorp, J.P. Morgan Co., and 

Bankers Trust to establish nonbank subsidiaries 

to underwrite and deal in certain securities (bank 

"ineligible" securities) to a limited extent, 

ihe prohibitions of Section 20 do not apply 

to member banks' securities affiliates that are not 

"principally engaged" in theimpermissibleactiv
FDIG Banking Review 

For these purposes, the FRB 

determined that a member bank's af 

filiate would not be "engaged princi 

pally" if its gross revenues, and its 

share of the total market, from such 

underwriting and dealing were below 

certain percentage thresholds. Ini 

tially, the revenues generated by 

these "ineligible securities" were lim 

ited to five percent of gross revenues 

and total market share. In 1988, the 

percent of total market share was 

dropped from the "engaged princi 

pally" test. In 1989, the revenue limit 

was raised to ten percent. Effective 

January 1993, the FRB introduced an 

alternative revenue test, indexed to 

interest-rate changes, that is intended 

to further ease the limits on the 

amounts of securities that the Section 

20 affiliates could underwrite.51 

Bank holding companies that en 

gage in these bank-ineligible securi 

ties activities through Section 20 

affiliates also are subject to capital ad 

equacy requirements, a number of 

limitations or firewalls, and FRB su 

pervision of the bank holding com 

pany and its Section 20 affiliate. As 

established by the FRB, these safe 

guards limit transactions between a 

Section 20 affiliate and its affiliates in 

order to manage potential risks, con 

flicts of interest, and competitive is 

sues raised by the activity. 

Legislative and Regulatory 

Changes. Recent legislation and reg 

ulations have affected the extent to 

which firewalls are present and oper 

ating in banking.52 Two pieces of leg 

islation, the Financial Institutions 

Reform, Recovery, and Enforcement 

Act of 1989 (FIRREA) and the Fed 

eral Deposit Insurance Corporation 

Improvement Act of 1991 (FDICIA), 

along with the regulations that imple 

ment them, have had a major impact 

on banking. 

The cross-guarantee provisions of 

FIRREA were designed to enable the 

FDIG to address the problems multibank holding companies may pose in 

failure-resolution situations. Under 

FIRREA, the FDIC is permitted to 

impose liability on commonly con 

trolled depository institutions to re 

coup any loss resulting from handling 

the failure of, or providing financial 

assistance to, an insured bank. The 

selective and judicious enforcement 

of these cross-guarantees is intended 

to protect the deposit insurance funds 

from losses stemming from interaffili

ate transactions by banks within a 

holding company. In this manner, 

cross-guarantees may reduce 

legislators' concerns about the risks 

posed by affiliations. 

FDICIA imposed restrictions on 

state banking powers. The intent was 

to ensure a "more level playing field" 

between state-chartered and national 

banks. Under FDICIA, a state-char 

tered bank is prohibited from engag 

ing as principal in an activity, either 

directly or through a majority-owned 

subsidiary, that is not permissible for 

a national bank unless the bank meets 

its minimum capital requirements 

and the FDIC determines that die 

activity does not present a significant 

risk to the insurance funds. In this 

manner, insured state-chartered 

banks are prohibited from making eq 

uity investments of a type or amount 

not permitted for national banks. 

FDICIA also placed a general prohi 

bition on insurance underwriting by 

insured state-chartered banks and 

their subsidiaries, However, an ex 

emption was provided for banks and 

their subsidiaries that were lawfully 

engaging in insurance underwriting 

on November 21,1991. 

The FDIC has proposed and 

promulgated regulations implement 

ing these provisions. In October 1992, 

final regulations implementing the 

equity investment restrictions were 

adopted. In general and subject to cer 

tain exceptions, the regulation pro 

hibits insured state-chartered banks 

from acquiring or retaining any equity 

investment that is not permissible for 

a national bank. In January 1993, the 

FDIC proposed regulations that 

would implement the activity restric 

tions. The proposal would establish 

procedures and criteria for state-char 

tered banks to seek approval, on a 

case-by-case basis, to engage in other 

wise prohibited activities. As well, the 

proposal sets out a tentative list of 

activities that would not present a sig 

nificant risk to the deposit insurance 

funds, including certain guarantee ac 

tivities, activities that are "closely re 

lated to banking," and securities 

activities conducted in a subsidiary. 

The proposal would clarify that the 

law does not impose new restrictions 

on activities where the bank is acting 

as an agent for a customer, and not 

acting "as principal." Final action on 

the proposed regulation is pending. 

Recent Developments. Two re 

cent developments concern the abil 

ity of banking organizations to engage 

in mutual fund and insurance activi 

ties. court ruling affirmed the right 

of certain national banks to sell insur 

ance, and the conditions under which 

banking organizations may provide 

retail mutual fund products and ser 

vices were addressed recently by the 

regulatory agencies. 

On July 16, 1993, the U.S. Court of 

Appeals for the District of Columbia 

Circuit, in Independent Insurance Agents 

of America v. Ludwig, upheld the right 

of national banks with branches in 

small towns to engage in retail insur 

ance agency activities from these 

branches on a nationwide basis. The 

SiSee Kumcza (1989) p. 1075, Christopher 

(Fall/Winter 1992), and Christopher 

(Spring/Summer 1993). In its July 1992 pro 

posal to adjust the ten percent revenue test, the 

FRB argued that changes in the level and struc 

ture of interest rates since the revenue test was 

last considered in 1989 could alter the measure 

of whether a Section 20 affiliate was "engaged 

principally" in ineligible securities in ways pre 

viously unforeseen. The FRB proposed a rev 

enue test that is indexed to interest-rate 

changes. Effective January 26, 1993, this alter 

native revenue test was made available to Sec 

tion 20 affiliates. 

Recent legislative attempts to expand 

bank powers have sought the repeal of GlassSteagall in conjunction with the use of firewalls 

to address possible conflicts of interest and 

other problems. Among these were the Finan 

cial Modernization Act of 1988 (S. 1866) and the 

1988 House Banking Committee bill, 

H.R.5094. While neither bill was passed by 

Congress, they remain an indicator of the belief 

that bank powers could be expanded if accom 

panied by appropriate firewalls. 
Banking and Commerce 

sale of insurance products by national 

banks located in small towns of popu 

lation 5,000 or less had been permit 

ted by the OCC.53 This ruling 

determined that the insurance cus 

tomer base of these banks was not 

limited to persons located in the small 

town. It is not clear whether the effect 

of this ruling will be to open retail 

insurance markets to national banks. 

Conceivably, these banks could en 

gage in a wide range of insurance 

agency activities including the sale of 

annuities, property and casualty in 

surance, and life and health insur 

ance. 

Banks' sales of mutual funds have 

grown rapidly in the recent period of 

low interest rates. Banks have been 

teaming with securities firms to offer 

mutual funds and other uninsured in 

vestment products to their customers 

from the bank office.54 This activity 

has stimulated Congressional inter 

est, as evidenced by the requests of 

Reps. Dingell and Gonzalez for stud 

ies by the General Accounting Office 

on the banking industry's approach to 

mutual funds and the impact of mu 

tual funds on the banking system. 

The regulatory agencies have es 

tablished guidelines concerning the 

sale of mutual funds, annuities, and 

other uninsured investment products. 

In June 1993, the FRB instructed its 

examination staff to review banks' 

disclosure practices with regard to the 

sale of uninsured investment prod 

ucts on bank premises and the banks' 

role as investment adviser. The 

OCG's guidelines for national banks, 

which were issued in July 1993, re 

quire banks to design their invest 

ment programs so that customers will 

understand the risks inherent in the 

uninsured investment products. The 

FDIC's guidelines for state-chartered 

nonmember banks concerning the 

sale of mutual funds and annuities 

were issued in October 1993. They 

emphasized the need to properly in 

form customers that these products 

are uninsured, and the importance of 

managing and administering sales 

programs prudently. 

These actions on the part of the 

regulatory agencies clarify the per 

missibility of bank mutual fund retail 

activities and provide guidelines con 

cerning how these activities should be 

conducted. They do not permit bank 

ing organizations to engage in under 

writing activities with these products. 

As such, they represent the further 

interpretation of, as opposed to a di 

rect challenge to, the Glass-Steagall 

separation of banking and commerce. 

Significantly, these activities are per 

ceived to pose risks to the safety net 

and deposit insurance funds that can 

be controlled adequately through the 

use of firewalls. 

Concluding Remarks 

The historical record shows many 

examples of banking and commerce 

mixing. Because a separation of bank 

ing from commerce has never domi 

nated American banking completely, 

firewalls, as safeguards or lines of sep 

aration, have existed throughout 

American banking history. They have 

been found, for example, in the vari 

ous prohibitions and proscriptions on 

bank activities that have been em 

bodied in bank charters and state and 

federal legislation. 

One result of this mixing of bank 

ing and commerce has been an evolv 

ing definition of what constitutes 

"appropriate" bank powers. In turn, 

the safeguards that are viewed as nec 

essary for maintaining the goals of 

bank regulation have evolved also. 

Banks' growing involvement in the 

retail sale of mutual funds and insur 

ance presents a recent example of the 

evolutionary nature of what consti 

tutes "banking." 

Over time, banks have been per 

mitted to engage in activities from 

which they subsequently were re 

stricted. One notable example has 

been banks1 securities activities. Al 

though banks had been the original 

investment bankers, and had securi 

ties powers throughout the free-bank 

ing period, the Glass-Steagall Act of 

1933 prohibited national and statechartered Federal Reserve member 

banks from engaging in securities ac 

tivities or affiliating with other firms 

that were so engaged. Conversely, 

prohibitions on certain activities that 

existed while banks had securities 

powers, such as trust and safe deposit 

businesses, were later rescinded. 

Firewalls are intended to facili 

tate the conduct of a range of activi 

ties, both within the bank and at the 

affiliate level, in a manner that does 

not threaten the insured depository. 

The scope of permissible activities 

has evolved over the course of Amer 

ican banking history, changing in re 

sponse to economic incentives, 

technological innovations and politi 

cal interests. Such change is likely to 

continue. In this context, well-de 

signed firewalls should facilitate the 

goals of bank regulation. As such, they 

should be viewed as a necessary, if not 

sufficient, tool in the pursuit of these 

goals. 

National banks have the power to sell 

insurance under the "incidental powers" clause 

of the National Bank Act, as allowed by OCC 

regulation, and Section 92 of Title 12 of the 

U.S. Code. This court ruling dealt with the 

insurance powers under Section 92. The sale 

ofinsurance products by state-chartered banks 

is controlled by the states and the banks' pri 

mary regulator. 

S4ln April 1993, the OCC permitted a sub 

sidiary of NationsBank to be a 50 percent gen 

eral partner with Dean Witter Financial 

Services Group. The partnership is subject to 

full regulation, supervision and examination by 

the OCC, and may engage only in those activi 

ties permissible for national banks. The part 

nership will be registered as a broker-dealer and 

therefore subject to federal and state securities 

laws. In an April 1993 order, the FRB permit 

ted Mellon Bank Corporation to acquire Boston 

Co., which provides administrative services to 

mutual funds. {American Banker, June 2, 1993.) 

37 
FDIG Banking Review 

REFERENCES 

American Banker. Z June 1993. 

Benston, George J. The Separation of Commercial and Investment Banking: The Glass-Steagall Act Revisited and 

Ibconsidered. New York: Oxford University Press, 1990, 

Board of Governors of the Federal Reserve System. The Bank Holding Company Movement to 1978: A Compendium. 

Washington, DC: Board of Governors of the Federal Reserve System, 1978. 

Bovenzi, John F. and Maureen E. Muldoon. "Failure-Resolution Methods and Policy Considerations." FDIC 

Banking Review 3 (1990):l-ll. 

Christopher, Benjamin B. "Recent Developments Affecting Depository Institutions." FDIC Banking Review 4 

(Spring/Summer 1991):35-57. 

Christopher, Benjamin B. "Recent Developments Affecting Depository Institutions." FDIC Banking Review 5 

(Fall/Winter 1992):34-58. 

Christopher, Benjamin B. "Recent Developments Affecting Depository Institutions." FDIC Banking Review 6 

(Spring/Summer 1993):31-59. 

Corrigan, E. Gerald. "The Banking and Commerce Controversy Revisited." Federal Reserve Bank of New York, 

Quarterly Review 16 (Spring 1991):1-13. 

Corrigan, E. Gerald. Financial Market Structure: A Longer View. New York: Federal Reserve Bank of New York, 

January 1987. 

Federal Deposit Insurance Corporation. Mandatefor Change: Restructuring the Banking Industry. Washington, DC: 

Federal Deposit Insurance Corporation, 1987. 

Federal Deposit Insurance Corporation. Report to Congress on the Findings and Recommendations Concerning the 

"Two-Window" Deposit System Proposal. Washington, DC: Federal Deposit Insurance Corporation, September 

1992. 

Golembe, Carter H. and David S. Holland. Federal Regulation of Banking. Washington, DC: Golembe Associates, 

Inc., 1981. 

Hammond, Bray. Banks and Politics in America from the Revolution to the Civil War. Princeton: Princeton University 

Press, 1957. 

Hammond, Bray. "Free Banks and Corporations: The New York Free Banking Act of 1838." Journal of Political 

Economy XLVI (February 1936): 184-209. 

Holland, David. "Bank Holding Company Activities," unpublished FDIC memorandum, October 1991. 

Huertas, Thomas F. "The Union of Banking and Commerce in American History." Appendix B to the Statement 

of Hans H. Angermueller, Vice Chairman Citicorp/Citibank, before the Commerce, Consumer and Monetary 

Affairs Subcommittee of the Committee on Government Operations, U.S. House of Representatives, 

Washington, DC, December 17, 1986. (mimeographed.) 

Klebaner, Benjamin J. American Commercial Banking: A History. Boston: Twayne Publishers, 1990. 

Kurucza, Robert M., Robert G. Ballen and Timothy R. McTaggart. "Securities and Investment Advisory Activities 

of Banks." The Business Lawyer44 (May 1989):1069-79. 

Miles, Veryl Victoria. "Banking Affiliate Regulation Under Section 23A of the Federal Reserve Act." The Banking 

Law Journal 105 (November-December 1988): 476-509. 

Moodys Investor Services. Moodys Investment Manual. New York: Moodys Investor Services, 1928. 

Peach, W. Nelson. The Security Affiliates ofNational Banks, Baltimore, MD: The Johns Hopkins Press, 1941. 

Symons, Edward L. Jr. "The 'Business of Banking' in Historical Perspective." The George Washington Law Review 

51 (August 1983):676-726. 

38 
Recent Developments 

Recent Developments 

Affecting Depository 

Institutions : • 1 

by Benjamin B. Christopher* 

Regulatory Agency Actions 

Inter-Agency Actions 

The federal bank and thrift regula 

tory agencies are engaging in joint or 

coordinated efforts in a number of 

regulatory areas that are mentioned 

specifically in this issue of the Review, 

among which are: safety-and-sound

ness standards, risk-based capital 

guidelines, implementation and en 

forcement of the Community Rein 

vestment Act (CRA), examination 

procedures forTruth-in-Savings com 

pliance, credit availability initiatives, 

fair lending initiatives, notices of 

branch closings, and regulatory relief 

for banks in disaster areas. 

Federal Deposit Insurance 

Corporation 

BIF Increases to $10.5 Billion 

in Third Quarter 

The Bank Insurance Fund (BIF) 

had net income of $10.6 billion in the 

nine months to September 30, 1993, 

and as a result the BIF increased to 

$10.5 billion (unaudited) from a neg 

ative $100.6 million at year-end 1992. 

The results in 1993 reflect very im 

portantly the fewer bank failures and 

reduced allowances for future losses. 

Provision for insurance losses and ex 

penses was a negative $6.05 billion for 

the first nine monthsof this year, com 

pared to a positive $1.61 billion for the 

same period in 1992. 

InitsJune30,1993 report—at that 

time the BIF was $6.8 billion (unaud 

ited)-— the FDIC noted that working 

capital borrowings from the Federal 

Financing Bank of $2.5 billion had 

been repaid. These Treasury bor 

rowings had peaked at$15.1 billion in 

September 1992. The improved re 

sults to June 30 reflected, in addition 

to the reduced reserving for losses, 

higher assessment income, and also 

cost containment, with new caps on 

spending and staffing levels. 

As of June 30,1993, the BIF had 35 

cents for every $100 of insured depos 

its. The FDIC said that assessments 

could not be reduced because the law 

requires that the fund reach a ratio of 

$1.25 for every $100 of insured depos 

its. Beginning in 1994, the FDIC is 

prohibited from reducing the average 

assessment rate charged to banks 

below 23 basis points until the fund 

has reached that designated reserve 

ratio. PR-93-93, FDIC, 8/10/93; Summary Fi 

nancial Management Report, Division of Finance, 

FDIC, Third Quarter 1993. 

Assessments 

The FDIC is amending its regula 

tion on assessments to establish a new 

risk-related assessment system, as re 

quired by Section 302<a) of the Fed 

eral Deposit Insurance Corporation 

Improvement Act of 1991 (FDICIA), 

to be implemented beginning with 

the assessment period commencing 

January 1, 1994. The amendments 

make limited changes to the existing 

"transitional" risk-related assessment 

system {see the Fall/Winter 1992 

issue of the Review, p. 34). Among 

the changes, the amendments clarify 

the basis on which supervisory sub 

group assignments are made by the 

FDIC; provide for the assignment of 

new institutions to the "well-capital 

ized" assessment group; clarify the 

basis, and report data, on which capi 

tal group assignments are made for 

insured branches of foreign banks; 

and expressly address lifeline accounts. 

in addition, the use of "experience fac 

tors" is being eliminated, beginning 

with theassessment period commencing 

January 1, 1995. FR, 6/25/93, p. 34357; 

FIL-4S-93, FDIC, 7/2; F1L-64-93,9/9. 

Sales ofNondeposit 

Investments 

The FDIC alerted state nonmem

ber banks to concerns and issues 

raised by bank sales of mutual funds 

and annuities. One such concern is 

the potential for customer confusion 

if a bank offers nondeposit invest 

ments at the same location where 

"Benjamin B. Christopher is a financial 

economist in the FDIC's Division of Research 

and Statistics. 

Reference sources: American Banker (AB); 

WallStreetJournal (VIS]); BNA's BankingReport 

(BBR); and FederalRegister(FR). 
FDIC Banking Review 

FDIC-insured deposits are solicited. 

Another is the potential for misman 

agement of the sales program, which 

could expose the bank to liability 

under the anti-fraud provisions of fed 

eral securities laws. 

Among the FDIC's comments 

were: 

Bank management should have 

control procedures to guard against 

risks in these sales activities, includ 

ing written policies and procedures 

governing the bank's involvement, 

and a compliance and audit program, 

independent of the sales program, to 

monitor the bank's mutual funds and 

annuity sales activities. 

Mutual funds and annuities should 

be promoted and sold, and the bank's 

sales activities administered, in a 

manner that clearly distinguishes 

such instruments from FDIC-insured 

deposits. The area in which mutual 

funds and annuities are sold should be 

clearly and prominently identified to 

distinguish such activities from tradi 

tional deposit-taking activities of the 

bank. Customers should be in 

formed that mutual funds and annui 

ties are not bank deposits, are not 

insured by the FDIC, and are not 

guaranteed by, or obligations of, the 

bank. Banks should consider requir 

ing customers to sign an acknowl 

edgement when a mutual fund or 

annuity account is opened to confirm 

thatthe customerreceived and under 

stands the disclosures. 

Banks have responsibility for en 

suring that sales personnel are prop 

erly qualified and trained to sell the 

nondeposit investment offered. If 

the bank recommends nondeposit in 

vestment products to customers, 

there should be appropriate docu 

mentation that the salesperson had 

reasonable grounds to believe the in 

vestment was suitable for the cus 

tomer at the time of the transaction. 

As part of regular safety-and

soundness examinations, FDIC ex 

aminers will review bank policies and 

procedures governing sales of mutual 

funds and annuities as well as 

management's implementation of 

and compliance with them. FIL-7I-93, 

FDIC, 1018193. 

Agencies Propose Safety-andSoundness Standards 

The Office of the Comptroller of 

the Currency (OCC), Federal Re 

serve Board (FRB), the FDIC, and 

the Office of Thrift Supervision 

(OTS) requested comments on all as 

pects of proposed safety-and-sound

ness standards, as required by Section 

132 of FDICIA (Section 39 of FDI 

Act). The proposed standards would 

formalize in regulation the funda 

mental standards used by the agen 

cies to assess the operational and 

managerial qualities of an institution, 

and are not a change in the agencies' 

policies. 

Under Section 39, the three types 

of standards must cover: 

(A) Operations and management. Final 

standards must relate to: internal 

controls, information systems, and 

internal audit systems; loan docu 

mentation; credit underwriting; 

interest-rate exposure; asset 

growth; and compensation fees 

and benefits. 

(B) Asset quality, earnings and stock val 

uation. The standards must specify 

a maximum ratio of classified as 

sets to capital; minimum earnings 

sufficient to absorb losses without 

impairing capital; and to the ex 

tent feasible, a minimum ratio of 

market value to book value for 

publicly traded shares of institu 

tions and holding companies. 

(C)Employee compensation. Final stan 

dards must prohibit excessive 

compensation or compensation 

that could result in a material fi 

nancial loss to an institution. The 

law also requires the agencies to 

prescribe standards specifying 

when compensation is excessive, 

FIL-79-93, FDIC, 12/3/93; FR, 11/18193, 

p. 60802. 

Enforcement of the 

Community Reinvestment 

Act 

The FDIC will seek public com 

ment on an inter-agency proposal to 

strengthen federal enforcement ofthe 

Community Reinvestment Act of 

1977 (CRA). The Act requires the 

four federal regulators of banks and 

thrifts to evaluate how their institu 

tions help meet the credit needs of 

the local communities, and to encour 

age loans and other services to lowand moderate-income areas. The 

CRA reform proposal was developed 

jointly with the OCC, FRB and OTS. 

The inter-agency proposal would 

replace 12 subjective factors now 

being used to assess an institution's 

CRA performance with three "tests" 

using objective, performance-based 

standards including: (I) lending test 

the bank or thrift would be evalu 

ated on loans made to low- and mod 

erate-income areas as well as other 

areas; (2) a service test — the in 

stitution's branch locations, their 

accessibility to low- and moderateincome areas, and the availability of 

credit and other services would be 

reviewed; and (3) an investment test 

this analysis would cover invest 

ment in community development 

programs that benefit low- and mod 

erate-income areas. 

The three tests would apply differ 

ently to different types of institutions, 

depending on their size or specialties. 

For example, relatively large institu 

tions (generally those with assets of 

$250 million or more) would be eval 

uated on additional information not 

now reported regarding the geo 

graphic distribution of their con 

sumer, small-business and small-farm 

loan applications, denials and origina 

tions. Smaller institutions would 

be evaluated under a streamlined 

method that would not include addi 

tional data on the geographic distribu 

tion of loans. Also, limited-purpose 

institutions that do not make a signif 

icant amount of loans as part of their 

normal business would not be subject 

to the same tests as the "retail" insti 

tutions that offer broad lending ser 

vices to the public. As an alternative 

to the three tests, an option would 

permit each institution to submit a 

strategic plan, to be open to public 

comment and subject to approval by 

the institution's primary regulator, 

that includes measurable goals for 

meeting its CRA obligations. PR-135-93, 

FDIC, 1219/93. 

40 
Recent Developments 

New Eocammation Procedures 

forTruth-in-Savings 

Compliance 

The FDIC and the four other fed 

eral regulators of depository institu 

tions have adopted inter-agency 

examination procedures for the Truth 

in Savings Act of 1991 (contained in 

Title II of FDICIA). The new pro 

cedures facilitate compliance with the 

FRB's Regulation DD implementing 

TISA. Compliance became manda 

tory on June 21, 1993. The examina 

tion procedures were adopted by the 

Federal Financial Institutions Exam 

ination Council (FFIEC) in July 1993. 

The agencies also are making avail 

able a computer software program 

that can assist institutions when cal 

culating the annual percentage yield 

for deposit accounts, as required 

under the new regulations. 

In general, Regulation DD covers 

accounts held by consumers at depos 

itory institutions. Its purpose is to 

enable consumers to make better-in 

formed decisions about accounts 

through the use of uniform disclo 

sures about the fees, annual percent 

age yield, interest rate and other 

terms for deposit accounts. Consum 

ers are entitled to receive the informa 

tion upon request, when an account is 

opened, when terms are changed, be 

fore the maturity of most time ac 

counts, and if a periodic statement is 

sent. Also, an institution must pay 

interest on the full balance in con 

sumer accounts each day, and must 

choose between the "daily balance" 

method, or the "average daily bal 

ance" method for calculating the bal 

ance for paying interest. FIL-50-93, FDIC, 

7/21/93. 

State Banks' Equity 

Investments and Activities 

The FDIC made available a list of 

equity investments and activities rec 

ognized by the OCC as permissible 

for national banks and their subsidiar 

ies. The list is not all-inclusive but 

provides insured state banks and their 

legal counsel some initial guidance. 

FDICIA puts new restrictions on ac 

tivities and investments of insured 

state banks and their majority-owned 

subsidiaries. In general and subject 

to certain exceptions, the amend 

ments prohibit an insured state bank 

from acquiring or retaining any equity 

investment that is not permissible for 

a national bank. An insured state 

bank also cannot either directly or in 

directly through a subsidiary engage 

as principal in any activity that is not 

permissible for a national bank unless 

the bank meets its capital require 

ments and the FDIC determines that 

the activity will not pose a significant 

risk to the deposit insurance fund. 

The FDIC in October 1992 adopted 

final regulations implementing the 

equity investment restrictions, and in 

January 1993 proposed regulations 

that would implement the activity re 

strictions. FIL-53-93, FDIC, 5/10/93. 

Advance Notice ofBranch 

Closings 

The FDIC adopted an interagency policy statement, effective 

September 21, 1993, implementing a 

statutory requirement that banks and 

thrifts provide advance notice of plans 

to close a branch. 

Section 228 of FDICIA generally 

requires each insured institution with 

branches to: 1) have a policy on 

branch closings; 2) give its federal reg 

ulator a 90-day advance notice of a 

proposed branch closing; 3) mail a no 

tice of a branch closing plan to cus 

tomers of the branch at least 90 days 

before the scheduled closing; and 4) 

place a conspicuous notice of the plan 

at the affected branch at least 30 days 

prior to the scheduled closing. The 

policy statement clarifies how the law 

will be enforced. For instance, a de 

pository institution that temporarily 

operates a branch of a failed bank or 

savings association but does not pur 

chase or lease the branch will be ex 

cluded from the advance notice 

requirements if it closes the branch 

before the end of any contractual op 

tion with the FDIC or the RTC to 

retain the branch. Also, the advance 

notice requirements will not apply to 

the closing of an automated teller ma 

chine or to a branch relocation. A 

branch relocation that is exempt from 

the closing notice requirements is 

defined as the closing of one office 

and the opening of another in the same 

immediate neighborhood, with the cus 

tomers served by the closed branch 

being substantially unaffected by the 

move. relocation involving a longer 

distance will be considered a branch 

closing and will be subject both to 

advance notice requirements and the 

FDIC's existing application rules for 

establishing new branches. PR-94-93, 

FDIC, 8110193; FIL-67-93, 9/24; FR, 9/21, pp. 

4S979,49083. 

Initiatives to Assist Flood-Area 

Rebuilding 

The FDIC is encouraging insured 

state-chartered banks "to work con 

structively with borrowers who are 

experiencing difficulties due to con 

ditions beyond their control" in Mid 

west states that have been damaged 

by recent serious flooding. Extend 

ing repayment terms, restructuring 

existing loans or easing terms for new 

loans, if done in a manner consistent 

with sound banking practices, "can 

both contribute to the health of the 

community and serve the long-run in 

terests of the lending institution," the 

FDIC said, Banks showing flexibil 

ity in working with borrowers in the 

affected areas "will not be subject to 

examiner criticism," if proper risk 

controls and management oversight 

are exercised. The unusual circum 

stances resulting from the flood will 

be considered when examining lend 

ers whose levels of delinquent and 

nonperforming loans increase. 

One provision for specific regula 

tory relief is a temporary waiver of 

certain real-estate appraisal regulations 

for the areas affected by the current 

flooding (see OCC section). Another is 

temporary relief from certain capital 

requirements if an already adequately 

capitalized bank, finds its asset levels 

increasing due solely to deposits of 

insurance proceeds or government as 

sistance funds. PR-87-93, FDIC, 7/22/93; 

FIL-52-93, FDIC, 7/23. 

Merger Application Notice 

Amendments Proposed 

The FDIC is proposing to amend 

its requirements for publishing notice 

of filing an application for a merger 

41 
FDIC Banking Review 

transaction under the Bank Merger 

Act. If an emergency exists requiring 

expeditious action, the applicant 

would be required only to publish 

twice during the statutory ten-day pe 

riod instead of daily for ten days. In 

non-emergency cases, the require 

ment would be deleted that notice be 

published on the same day for each of 

the five weeks on which notice must 

be published and on the 30th day 

from the first publication. These 

proposed amendments would bring 

the FDIC's regulations more into 

conformance with those of the other 

federal banking agencies, give appli 

cants more flexibility, and lessen the 

paperwork and cost burdens imposed 

by the FDIC's current notice require 

ments. FR, 6(15193,p. 33050. 

Recovery Using 

Cross- Guaranty Assessment 

The FDIC recovered $1.3 million 

from a Texas bank after invoking the 

cross-guaranty provisions of the Fed 

eral Deposit Insurance Act, marking 

the first time the FDIC has used suc 

cessfully the authority to recover its 

losses in full without causing the pay 

ing bank's failure. Bank of Kerrville 

made the payment following the 

FDIC's assessment for its anticipated 

loss due to the failure of Texas Pre 

mier Bank of Victoria, Texas. Pre 

mier Bank, which failed in 1991, and 

Bank of Kerrville were both subsidi 

aries of Premier Bancshares, Inc., 

Kerrville. Bank of Kerrville subse 

quently merged with First National 

Bank of Kerrville. The FDI Act was 

amended by the Financial Institutions 

Reform, Recovery, and Enforcement 

Act of 1989 (FIRREA) to give the 

FDIC authority to assess bank subsid 

iaries of holding companies for losses 

to the Bank Insurance Fund from the 

failure of other banks owned by the 

same holding company. Prominent ex 

amples of the prior use of this author 

ity are the former Texas American 

Bancshares, Inc., Houston; MCorp, 

Dallas; Bank of New England Corpo 

ration, Boston; Southeast Bancorp, 

Miami; and First City Bancorpora

tion, Dallas. PR-1I3-93, FDIC. 9120193. 

Survey Finds Recovery in 

Real-Estate Markets 

Continuing 

Improvement in real-estate mar 

kets across the nation has broadened 

in recent months, according to the 

FDIC's survey of real-estate markets 

in October. The national composite 

index of real-estate trends remained 

at 67, having risen to that level in July, 

from 66 in April, and from 57 in Octo 

ber 1992. The index of residential 

markets nationally stood at 72, and the 

commercial market index registered 

61 in October. 

The surveys, which began in April 

1991, are based on interviews across 

the country with more than 450 senior 

examiners and asset managers at fed 

eral bank and thrift regulatory agen 

cies. Values of the index above 50 

indicate that more respondents be 

lieved conditions were improving 

than declining, compared to the pre 

vious quarter, while values below 50 

indicate the opposite. 

The report said the improving con 

ditions have begun to reduce excess 

supply in real-estate markets. The 

largest improvement between July 

and October occurred in the commer 

cial markets, where respondents who 

reported excess supply declined from 

82 percent to 75 percent. In residen 

tial markets, which are in much better 

shape in respect to excess stock, there 

was a decline from 45 percent to 43 

percent. 

More respondents reported im 

provement than decline in all regions. 

The index for the West of 54 was the 

lowest in the nation. This reflected 

the continuing weakness in Califor 

nia, where 45 percent of respondents 

saw a worsening in commercial realestate markets, and 40 percent re 

ported negative trends in the residen 

tial sector. However, the data for 

California were less negative than in 

other recent surveys. Evidence sug 

gests that conditions in real estate in 

the Northeast region are improved, as 

over half of the respondents reported 

housing markets firmed in the past 

three months, while only three per 

cent saw a declining trend. In the 

Northeast's commercial real-estate mar 

kets, less than ten percent of respon 

dents reported a further weakening, 

while almost 30 percent believed con 

ditions are improving. The latter was 

the highest percentage thus far in the 

surveys. The strongest regional up 

trends, particularly in respect to resi 

dential markets, continue to be 

experienced in the South and the Mid 

west, where only scattered reports of 

weakening were received. Survey of Real 

Estate Trends, FDIC, October 1993. 

Resolution Trust Corporation 

Small Investor Program 

The RTC has developed a com 

prehensive Small Investor Program (SIP) 

to increase opportunities for individ 

ual investors or groups with moderate 

resources to purchase real estate and 

other assets. Individual real-estate 

offerings, smaller asset pools, and 

more localized auctions will become 

more common. Special initiatives 

will encourage the participation of 

small investors (including minorityand women-owned businesses) in the 

RTC's larger asset offerings. 

The program is targeted for poten 

tial investors in real estate owned 

(REO) asset offerings of up to $5 mil 

lion or loans up to $25 million, or eq 

uity investments of up to $9 million in 

joint venture transactions. The ef 

fective capital contribution in many 

offerings may be reduced further by 

taking advantage of up to 85 percent 

in RTC seller financing. 

Among the features of the program 

are: a) each new REO asset is to be 

available for stand-alone purchase for 

at least 120 days; b) auctions of REO, 

nonperforming loans, and furniture, 

fixtures and equipment will be held 

more frequently, and their geographic 

focus will be narrowed to ensure that 

local investors have ample opportuni 

ties to purchase assets; c) the refund 

able bidder entry deposit for 

nonperforming loan auctions will be 

reduced from $100,000 to $50,000; 6) 

smaller portfolios of geographically 

concentrated nonperforming loan as 

sets with a maximum pool size of $10 

million (book value) are to be offered; 

and d) a new "S" Series Program will 

be piloted, in which an investor will 

need private equity of no more than 

$9 million in order to compete for 

42 
Recent Developments 

participation in $25 million to $60 mil 

lion joint-venture partnerships with 

the RTC. The RTC Investor, June 1993, p. I. 

National Nonperforming 

Loan Auctions 

The RTC reported that, since June 

1991, it has sold slightly more than $1.5 

billion in hard-to-sell nonperforming 

loans through open auctions. For a 

mortgage loan to be considered non

performing and included in the auction 

program, it must be at least 120 days 

delinquent. Loans not secured by real 

estate will be considered for auction 

when they are 90 days delinquent. 

About half of the loan volume sold in 

the two-year period consisted of resi 

dential mortgages which returned, on 

average, about 65 percent of book 

value. Other loans secured by real es 

tate, such as construction loans and 

commercial mortgages, have averaged 

between 44 and 62 cents on the dollar. 

Less-well-secured consumer and com 

mercial loans have sold at prices averag 

ing about 28 percent of book value. The 

RTC Investor, August 1993,p. 8. 

GAO FinancialAudit 

The General Accounting Office 

(GAO) reported that, in its opinion, 

the RTC's financial statements pres 

ent fairly, in all material respects and 

in conformity with generally accepted 

accounting principles, its financial po 

sition as of December 31, 1992 and 

1991, the results of its operations and 

accumulated deficit for the year end 

ing December 31, 1992, and its cash 

flows for the years ending December 

31, 1992 and 1991. The auditor did 

not express an opinion on the state 

ment of revenues, expenses and accu 

mulated deficit for the year ended 

December31, 1991. 

The report said that the RTC's 

internal accounting controls in effect 

on December31, 1992, provided rea 

sonable assurance thac assets are safe 

guarded against loss and that 

transactions are executed in accordance 

with management's authority and with 

significant provisions of laws and reg 

ulations. However, due to a material 

weakness in the RTC's loss calcula 

tion procedures, controls were not 

effective in providing reasonable as 

surance that the agency properly re 

corded, processed, and summarized 

transactions for its financial state 

ments or other financial reports. The 

GAO's tests in 1992 for compliance 

with the significant provisions of se 

lected laws and regulations disclosed 

no material instances of noncompli

ance, and there were no other indica 

tions that material noncompliance 

with such provisions occurred. 

As of March 31, 1993, the RTG's 

receiverships and conservatorships 

held $91 billion in assets of which more 

than 40 percent were delinquent loans, 

real estate owned, and investments in 

the subsidiaries of failed institutions. 

Because these assets are considered 

among its hard-to-sell assets, it is dif 

ficult for the RTC to predict the re 

covery value and timing of sales. The 

GAO found the reserves for future 

securitization losses and for claims aris 

ing from representations and warranties 

to be reasonable. However, it cau 

tioned that the RTC's claims experi 

ence to date has been very limited and 

cannot be relied upon to predict the 

nature or amount of future losses. 

Such losses will be affected by the be 

havior of the economy, interest rates, and 

real-estate markets as well as the per 

formance of the collateral underlying 

the transactions. Financial Audit Resolu 

tion Trust Corporation's 1992and1991 Financial 

Statements, GAO, June 1993. 

Operations Update 

Assets under the RTC's manage 

ment on July 31, 1993, including both 

conservatorships and receiverships, 

totaled $79 billion, down from $91 

billion on March 31. The decrease in 

assets reflects the ongoing sales effort 

by the RTC to reduce its conservatorship and receivership inventory. The 

assets in July consisted of $15 billion in 

cash and securities, $9 billion in per 

forming l-to-4 family mortgages, $13 

billion in other performing loans, $17 

billion in delinquent loans, $9 billion 

in real estate, and $16 billion in other 

assets. 

The 78 conservatorships held $34 

billion in gross assets on July 31,1993. 

Assets in receiverships remaining 

from the institutions closed by the 

RTG amounted to $45 billion on July 

31. Because many of the relatively 

marketable assets have been sold be 

fore an institution enters a receiver 

ship, most of the assets retained by 

the RTC in receiverships consisted of 

lower-quality, less-marketable assets. 

Thus, real estate and delinquent loans 

represented 47 percent of receiver 

ship assets, while cash, securities, and 

performing l-to-4 family mortgages 

represented only 12 percent. 

From its inception in August 1989 

through July 1993, the RTC collected 

$136 billion from securities, $98 bil 

lion from 1 -to-4 family mortgages, $47 

billion from other mortgages, $26 bil 

lion from non-mortgage loans, and 

$30 billion from other assets. Book 

value asset reductions (assets sold or 

collected, net of putbacks to RTC) 

were $372 billion, on which the RTC 

recovered 91 percent. From incep 

tion, the RTC has recovered 98 per 

cent from securities, 97 percent from 

l-to-4 family mortgages, 82 percent 

from other mortgages, 92 percent 

from non-mortgage loans, 58 percent 

from real estate, and 76 percent from 

other assets. 

As of the end of August, RTC res 

olutions had protected 22.1 million 

deposit accounts from financial loss. 

There were 662 thrift closings from 

the RTC's inception through July 31, 

and these thrifts held $217 billion in 

assets at the time of closure. The 

estimated resolution cost for the 662 

closed thrifts totaled $79.6 billion. If 

the insured deposits of all 662 institu 

tions had been paid out to depositors, 

the estimated resolution cost would 

have been $82.8 billion. Of the 662 

cases, 415 were purchase-and-assump

tion transactions (P&As), 158 were 

insured-deposit transfers (IDTs), and 

the remaining 89 were insured-deposit 

payoffs (POs). Most of the attractive 

franchises were resolved using P&As, 

and these acquirers paid considerably 

higher premiums over deposit payoff 

costs: 2.44 percent of core deposits, 

compared to 0.67 percent for IDTs. 

Although only 63 percent of RTC res 

olutions were P&As, these transac 

tions accounted for 80 percent of the 

43 
FDIC Banking Review 

deposits that have been made whole 

by the RTC from its inception 

through July 1993. RTC Review, September 

1993. 

GAO Report on Minority/Women 

Businesses Outreach 

FIRREA requires the RTC to use 

private contractors whenever practi 

cable and efficient The Act man 

dates that the RTG ensure inclusion 

to the maximum extent possible of 

businesses owned by minorities and 

women, including law firms, in all 

RTG contracts. The RTG Refinanc 

ing, Restructuring, and Improvement 

Act of 1991 placed additional require 

ments on the outreach program. For 

example, the Act required RTG to 

provide additional incentives to mi 

nority- and women-owned businesses 

(MWOB) by increasing the bonus 

points that these businesses may re 

ceive in the evaluation process. Bonus 

points are designed to increase the com 

petitive position of acceptable MWOB 

proposals relative to the proposals of 

non-MWOBs. In August 1992, RTG 

issued its directive on evaluation of pro 

posals and application of bonus points. 

The RTC strengthened the outreach 

program by creating an Office of Minor 

ity and Women Outreach and Contract 

ing Program in December 1991 and by 

consolidating its business and legal pro 

grams under one department in No 

vember 1992. In May 1992, the RTC 

also established agencywide goals to 

award 30 percent of its contracts and 

related fees to MWOBs and to award 20 

percent of its legal fees to minority- and 

women-owned law firms (MWOLF). 

Since August 1989, the RTC has 

awarded over 105,000 contracts with 

estimated fees totaling about $3 bil 

lion. In 1992* about 45,000 contracts 

with estimated fees of about $1.13 

billion were awarded. Of the con 

tracts awarded in 1992, MWOBs were 

awarded over 15,000 with estimated 

fees of $323 million or 28 percent of 

the $1.13 billion paid by RTC. This 

represents a larger percentage of the 

total fees paid when compared to ear 

lier years. 

MWOLFs received $36 million, or 

over ten percent, of the total $351 

million paid by RTC for all legal ser 

vices in 1992. Fees paid to 

MWOLFs in 1992 for receiverships 

and corporate legal matters were sig 

nificantly higher than fees paid in 

1990 and 1991. 

Minority- and women-owned in 

vestment firms also participated in 

RTC's securitization program in 

1992. Nine minority- and womenowned investment firms underwrote 

$884.5 million, or four percent, of the 

$22 billion of mortgage-backed secu 

rities issued by RTC in 1992. 

The RTC recognizes that more 

work is needed to enhance opportuni 

ties for MWOBs and MWOLFs. 

The Thrift Depositor Protection 

Oversight Board has directed the 

RTC to make a number of im 

provements, such as developing ways 

to provide more opportunities for 

MWOBs in the management and dis 

position of all its assets. RTC is de 

veloping a plan to implement these 

initiatives. RTC: Status ofMinority andWomen 

Outreach and Contracting Program, U.S. General 

Accounting Office, May 1993. 

Federal Reserve Board 

Extensions ofCredit 

by FR Banks to 

Undercapitalized Institutions 

The FRB proposed revising its 

Regulation A to implement Section 

142 of FDICIA and discourage ad 

vances to undercapitalized and criti 

cally undercapitalized depository 

institutions. The Section imposes li 

ability on the FRB for certain losses 

incurred by the funds administered 

by the FDIC. Specifically, the FRB 

incurs limited liability for increased 

losses attributable to Federal Reserve 

Bank advances under Section 10B of 

the Federal Reserve Act to an under 

capitalized insured depository institu 

tion after that institution has 

borrowed for 60 days in any 120-day 

period. The 60 days may be ex 

tended for additional 60-day periods 

with a determination by the Chairman 

or the head of the appropriate federal 

banking agency that the institution is 

viable. The FRB also incurs limited 

liability for increased losses attribut 

able to Section 10B advances to a crit 

ically undercapitalized insured de 

pository institution after a five-day 

period beginning on the day the insti 

tution becomes critically undercapi 

talized. The FRB's liability for these 

increased losses is limited to the lesser 

of the amount of the loss that the FRB 

or a Federal Reserve Bank would 

have incurred on any increases in the 

amount of advances after the expira 

tion of the applicable lending period 

if those advances had been unse 

cured, or the amount of interest re 

ceived on the increased amount of the 

advances. The FRB must report to 

Congress on any such liability it in 

curs. 

The principal substantive changes 

as proposed are: 1) placing limitations 

on Federal Reserve Bank credit to 

undercapitalized and critically under 

capitalized insured depository institu 

tions; 2) describing the loss 

calculations; 3) definingundercapital

ized and critically undercapitalized 

insured depository institutions; 4) de 

fining viable, as it applies to an under 

capitalized insured depository 

institution; and 5) providing for as 

sessments on the Federal Reserve 

Banks for amounts that the FRB may 

be required to pay the FDIC under 

Section 142. FR, 8131/93,p. 45851. 

Loans to Insiders 

The FRB proposed revisions to its 

Regulation O (loans to executive offi 

cers, directors, and principal sharehold 

ers of member banks) which would: a) 

provide an exception to the aggregate 

insider lending limit for the purchase 

of certain installment paper, b) modify 

the definition of "extension of credit" 

to exclude the discount of obligations 

sold by an insider to the bank without 

recourse, increase from $5,000 to 

$15,000 the threshold for considering 

credit-card plan debt to be an exten 

sion of credit, and clarify a part of the 

definition; c) modify the recordkeep

ing requirements to allow banks greater 

latitude in procedures for ensuring 

compliance with the regulation, and re 

vise the limits-on lending to execu 

tive officers to exempt home mortgage 

refinancing and certain collateralized 

44 
Recent Developments 

loans. The proposed amendments 

are intended to increase the ability of 

banks to make extensions of credit 

that pose minimal risk of loss, to re^ 

move other transactions from the 

regulation's coverage, and to elimi 

nate recordkeeping requirements 

that impose a paperwork burden but 

do not significantly aid compliance 

with the regulation. Press Release, FRB, 

913193; FR, 919, p. 47400. 

Rejection ofApplication Cites 

Lending Bias 

The FRB in a 3-to-3 vote declined 

to approve an application by 

Shawmut National Corporation, New 

England's third largest bank holding 

company, to acquire New Dartmouth 

Bank of Manchester, New Hamp 

shire, citing concerns regarding 

Shawmut's full compliance with fair 

lending laws. In particular, refer 

ence was made to the Equal Credit 

Opportunity Act, which requires 

lenders to treat all applicants equally, 

and the Home Mortgage Disclosure 

Act, which requires lenders to submit 

information about their mortgage 

lending. AB, 11/17/93, p. 3. 

Following a one-year investiga 

tion, the U.S. Department of Justice 

announced a settlement with 

Shawmut National Corp., in which 

the lender agreed to set up a fund of 

at least $960,000 to compensate black 

and Hispanic applicants for home 

mortgage loans that were unfairly re 

jected between January 1990 and Oc 

tober 1991. Shawmut also will 

continue its program already im 

plemented for increased lending to 

minorities. AB, 12114, p. l. 

Banks Given Expanded 

Futures Authority 

The FRB significantly broadened 

[he authority of bank holding com 

panies to engage in futures trading, 

permitting the Bank of Montreal to 

execute and clear futures and options 

based on certain commodities. These 

futures transactions previously were al 

lowed only for contracts pegged to fi 

nancial instruments such as Treasury 

bonds or foreign currencies. Foreign 

banks, in particular, are expected to 

benefit from the approval since do 

mestic holding companies have had 

this authority through national bank 

subsidiaries which already are author 

ized to participate in nonfinancial fu 

tures markets. AB, 1014193, p. 3. 

Collateral Inspection Services 

The FRB gave approval for 

NationsBank Corp. to create an Allen

town, Pennsylvania company to pro 

vide collateral inspection services for 

inventory financing. The FRB said 

the new service should increase the 

availability of inventory financing, and 

also encourage competitors, including 

the smaller financial institutions, to 

enter the inventory financing market. 

BBS., 9120J93, p. 425. 

Penalty Fee on Daylight 

Overdrafts ofCertain 

Institutions 

The FRB proposed a rate at which 

Federal Reserve Banks will assess a 

penalty fee on the average daily day 

light overdrafts of bankers' banks that 

do not maintain reserves, Edge and 

agreement corporations, and limitedpurpose trust companies. The proposed 

rate would be equal to the federal funds 

rate plus the overnight overdraft pen 

alty rate, quoted on a 24-hour basis, 

for a 360-day year, and adjusted for 

the length of the Fedwire operating 

day. The fee should create an incen 

tive for institutions that do not have 

regular discount window access to avoid 

incurring daylight overdrafts in Federal 

Reserve accounts. FR, 8/24/93, p. 44672. 

Records ofFunds Transmittals 

by Financial Institutions 

The Treasury Department and FRB 

jointly proposed enhanced recordkeep 

ing requirements relating to certain wire 

transfers {which include funds transfers 

and transmittals of funds) by financial 

institutions. Each domestic financial 

institution involved in wire transfer will 

have to collect and retain certain infor 

mation. The amount and type of infor

mation collected and retained will 

depend upon the nature of the finan 

cial institution, its role in the particu 

lar wire transfer, and the relationship 

of the parties to the transaction with 

the financial institution. The proposal 

also would amend the existing regula 

tion that permits theTreasury Depart 

ment to require reports of certain 

transactions with targeted foreign finan 

cial institutions to permit the Treasury 

Department to require reports of all 

wire transfers by financial institutions. 

In addition to retention of records, 

having certain customer identity infor 

mation (/.?., the originator's and 

beneficiary's name, address and account 

number) included in the payment order 

has a high degree of usefulness for law 

enforcement purposes. As an interim 

measure, theFFIEC is encouraging all 

financial institutions to include> to the 

extent practical, complete originator 

and beneficiary information when 

sending payment orders, including pay 

ment orders sent through Fedwire, 

Clearinghouse Interbank Payment Sys 

tem (CHIPS) and Society for Worldwide 

Interbank Financial Telecommunica 

tions (SWIFT). 

The Treasury Department pro 

posed to amend the regulations that 

implement the Bank Secrecy Act 

(BSA) to require a bank or non-bank 

financial institution that acts as a 

transmitter's financial institution in a 

transmittal of funds to include certain 

information in the transmittal order 

when sending it to the receiving fi 

nancial institution. FR,8/31/93,pp. 45851, 

46014, 46021, 46024. 

Interest-Rate Risk at 

Commercial Banks 

Using the March 1993 version of 

the Federal Reserve's proposed meth 

odology for measuring interest-rate 

risk, a preliminary assessment of this 

risk at U.S. commercial banks has been 

made from data currently available in 

bank Call Reports. 

The FRB has proposed a risk mea 

surement system to begin in 1994 

wherein banks would provide detailed 

data on the maturity and cash-flow char 

acteristics of their assets and liabili 

ties. Based on these features, one set 

of risk-weights would be assigned to 

liabilities, and one set each assigned 

to amortizing, nonamortizing, and deepdiscount assets. Holdings in each cat 

egory would be multiplied by the 

45 
FDIG Banking Review 

appropriate risk factor, representing 

the change in the value of the bank's 

position in that category that would 

result from a rise in interest rates. 

Regulators could determine how 

much a bank's net worth would 

change in response to a given parallel 

shift in interest rates. As proposed, 

the risk measurements may be used in 

the determination of banks' capital 

requirements. Weekly Letter No. 93-26, Fed 

eral Reserve Bank ofSan Francisco, 7123193. 

Limited maturity information has 

been reported since the fourth quarter 

of 1989 on bank holdings of fixed- and 

floating-rate loans, securities, and large 

CDs. Cash-flow characteristics of 

banks' assets are not currently reported 

and several assumptions were required 

for loan amortizations. The FRB's 

proposed guidelines for the allocation 

of liabilities across different maturity 

bands were used to determine the ma 

turities of bank deposits and other lia 

bilities. Risk-weightings were 

determined using the risk factors in the 

FRB's proposal. The analysis does not 

encompass off-balance-sheet activities 

due to lack of information. These ac 

tivities may pose considerable risk; 

however, they also may be used for 

hedging, thus the effect of their omis 

sion here is regarded as uncertain. 

Interest-rate risk is measured by 

the change in banks' net worth result

ingfrom a 200-basis point rise in inter 

est rates, divided by total bank assets. 

A value of 1.0 indicates that a 200

basis point increase in rates would re 

duce bank net worth by one percent 

of assets. The measured riskstood at 

0.85 percent in the first quarter of 

1993, having ranged, since the last 

quarter of 1988, from a low of slightly 

under 0.70 percent in the first quarter 

of 1989 to a high of almost one percent 

in the third quarter of 1990. With 

due consideration for the limitations 

of the data, the conclusion is that risk 

is within the normal range for the in 

dustry, and for banks as a group it has 

not risen much in recent years. 

Survey on Bank Lending 

Practices 

The results of the August 1993 Se 

nior Loan Officer Opinion Survey on 

Bank Lending Practices show that 

easing of lending terms and standards 

is continuing and demand for bank 

credit is strengthening on the part of 

both households and businesses. 

The survey queried bankers on 

several issues, among which were 

changes in bank lending standards 

and terms, changes in loan demand by 

businesses and households, and bank 

capital levels. A total of 78 domestic 

commercial banks and U.S. branches 

and agencies of foreign banks partici 

pated in the survey. 

There were more reports of some 

easing of terms and standards for com 

mercial and industrial loans than in 

the May survey. Banks made little 

change in their standards for commer 

cial real-estate loans, which remain 

very restrictive. There was some easing 

of standards on home mortgage loans, 

and still more reports of increased will 

ingness to make loans to individuals. A 

number of respondents indicated that 

the demand for business loans had in 

creased over the last three months. 

Household demand for bank credit was 

reported to have improved also, particu 

larly for residential mortgages, 

Almost all respondents believed their 

bank's capital position to be either fairly 

comfortable or very comfortable, as they 

did in the last four surveys. Those whose 

comfortable capital position caused them 

to be more aggressive lenders increased 

from one-fifth in May to more than onethird in August. However, most of 

those taking a more aggressive lending 

stance continued to report difficulty in 

finding attractive lending opportunities. 

The Credit Availability Program 

appears thus far to have had little ef 

fect on lending, although respondents 

expect that it will allow some easing 

of terms and standards for loans when 

fully implemented. National Summary of 

theAugust 1993 SeniorLoan Officer Opinion Survey 

on Bant Lending Practices, FRB, 8125193. 

Office of the Comptroller of 

the Currency 

Risk-Based Capital and 

Interest-Rate Risk 

The OCC, FRB and the FDIC pro 

posed revisions, implementing Section 

305 of FDICIA, to their risk-based 

capital guidelines to ensure that those 

standards take adequate account of in 

terest-rate risk (IRR). An initial re 

quest for comments was issued in 

August 1992. The proposed revisions 

would provide for the explicit consider 

ation of IRR when assessing the capital 

adequacy of an institution. The pro 

posal encompasses a measure of IRR 

exposure, and an approach for assessing 

capital adequacy for IRR. Exposures 

to IRR would be measured as the effect 

that a specified change in market inter 

est rates would have on the net eco 

nomic value of a bank. This economic 

perspective considers the effect that 

changing market interest rates may 

have on the value of a bank's assets, 

liabilities, and off-balance-sheet posi 

tions. 

The agencies propose to measure 

an institution's exposure using either 

a supervisory model or the bank's own 

internal model. In either case, the 

results could be used in one of two 

ways when assessing capital adequacy 

for IRR. One approach would be to 

reduce an institution's risk-based cap 

ital ratios by an amount based on the 

level of measured risk. The other 

would be to use the measured expo 

sure as only one of several factors in 

assessing the need for capital. 

The supervisory model would re 

quire banks to report their assets, lia 

bilities and off-balance-sheet 

positions into time bands, based upon 

their remaining maturities or nearest 

repricing dates. Each position then 

would be multiplied by an IRR "risk

weight" developed by the agencies 

that represents the estimated sensi 

tivity of the economic value of that 

position to a specified change in mar 

ket interest rates. The risk-weighted 

positions of all balances would be 

summed to produce a net riskweighted position. This net position 

represents the estimated change in 

the bank's net economic value and 

would be the primary quantitative 

measure used to assess a bank's level 

of IRR. 

The agencies recognize that many 

banking institutions have sophisti 

cated internal models for measuring 

46 
Recent Developments 

IRR that take account of complexities 

not addressed in the basic supervisory 

model and that are tailored to circum 

stances at each bank. Consequently, 

the agencies propose to make use of 

a bank's own IRR model if it is 

deemed adequate by examiners. To 

make this determination, examiners 

would consider the types of instru 

ments held or offered by the bank, the 

integrity of the data, and whether the 

assumptions and relationships under 

lying the model are reasonable. 

To minimize the reporting and 

other regulatory burdens associated 

with this proposal, the agencies also 

propose a quantitative screen that 

would exempt from additional report 

ing requirements the banks identified 

as having potentially low interest-rate 

risk. Based on data for December 31, 

1992, the agencies estimate approxi 

mately 8,400 institutions, with about 

30 percent of U.S. commercial bank 

assets, would be exempt from addi 

tional reporting. 

Under the proposal, additional re 

porting by non-exempt banks would 

begin with the March 1994 Call Re 

ports. Full implementation of the 

guidelines for assessing the adequacy 

of bank capital would be effective 

December 31, 1994. However, the 

agencies also propose that examiners 

apply these standards on an advisory 

basis beginning with examinations 

commencing after December 31, 

1993, to the extent that data are rea 

sonably available. FR, 9114193, p. 48206; 

FIL-65-93, FDIC, 9/20. 

Credit Availability Initiatives 

The four federal regulators of 

banks and thrifts announced addi 

tional initiatives to implement the 

President's March 10, 1993 program 

to improve the availability of credit to 

businesses and individuals. The ac 

tions cover the following areas: 

a) In-Substance Foreclosures. 

Under existing accounting guidelines 

for determining whether the collat 

eral for a loan has been in-substance 

foreclosed, a loan is transferred to 

"other real estate owned" (OREO or 

REO) and appropriate losses are rec 

ognized if certain criteria are met. 

Such OREO designations may im 

pede efforts to improve credit avail 

ability and may discourage lenders 

from working with borrowers experi 

encing temporary financial difficul 

ties. The revised guidance clarifies 

that a collateral-dependent real-es 

tate loan need not be reported as fore 

closed real estate unless the lender 

has taken possession of the collateral. 

However, appropriate losses must be 

recognized. 

b) Returning Nonaccrual Loans to 

Accrual Status. In the past, a loan 

that was partially charged off could 

not be returned to accrual status until 

all missed payments had been made 

up to bring the loan to current status 

and the institution expected to re 

ceive the full contractual principal 

and interest on the loan. This re 

quirement also applied in situations 

where the borrower showed a re 

newed ability and willingness to ser 

vice the remaining debt. One 

change is that banks and thrifts wil I be 

allowed to formally restructure trou 

bled debt to allow a portion of the 

debt to become an accruing asset, pro 

vided certain criteria are met. This 

revised reporting guidance makes the 

policies of the bank and thrift regula 

tory agencies consistent. Second, 

when borrowers have resumed paying 

the full amount of scheduled contrac 

tual principal and interest payments 

on loans that are past due and in nonaccrual status, banks and thrifts will 

be allowed to return such loans to 

accrual status,provided the institution 

expects to collect all principal and in 

terest due and the borrower has made 

regular payments in accordance with 

the terms of the loan over a specific 

period of time. 

c) Regulatory Reporting Require 

ments for Sales of Other Real Estate 

Owned. The agencies separately 

will issue guidance to banks and 

thrifts that generally conforms regula 

tory reporting requirements for sales 

of OREO with generally accepted ac 

counting principles. 

d) Review and Classification of 

Commercial Real-Estate Loans. A 

policy statement reiterates that the 

evaluation of commercial real-estate 

loans is based on a review of the 

borrower's willingness and capacity 

to repay and on the income-produc 

ing capacity of the underlying collat 

eral over time. It is not regulatory 

policy to value collateral that under 

lies real-estate loans on a liquidation 

basis. 

e) Supervisory Definition of Spe 

cial Mention Assets. The agencies 

are concerned that improper use of 

the "Special Mention" loan category 

in examiners* reviews may inhibit lend 

ing to small- and medium-sized busi 

nesses. Accordingly, all four agencies 

have adopted a uniform definition for 

this category. Special Mention asset 

is defined as an asset that has potential 

weaknesses that deserve management's 

close attention. If left uncorrected, 

these potential weaknesses may result 

in deterioration of the repayment pros 

pects for the asset or in the institution's 

credit position at some future date. 

The agencies have agreed to use classi 

fied assets, which by definition do not 

include Special Mention assets, as the 

standard measure in expressing the 

quality of a bank or thrift's asset port 

folio. 

0 Coordination of Holding Com 

pany, Thrift and Bank Examinations, 

An inter-agency policy statement out 

lines a program for coordinating ex 

aminations of insured depository 

institutions and inspections of their 

holding companies. The objective is 

to minimize disruption and avoid du

plicative examination activities, when 

ever possible. Examinations and 

inspections of an entity will be con 

ducted by the primary supervisor for 

that entity. The program includes: 

coordinating the planning, timing and 

scope of examinations and inspections 

of federally insured depository insti 

tutions and their holding companies; 

conducting joint inter-agency examina 

tions or inspections, when necessary; 

coordinating and conducting joint 

meetings between bank or bank hold 

ing company management and the reg 

ulators; coordinating information 

requests; and coordinating enforce 

ment actions, when appropriate. Joint 

Statement, OCC, FDIC, FRB, OTS, 6/10/93. 

47 
FDIC Banking Review 

Fair Lending Initiatives 

The four federal bank and thrift 

regulatory agencies announced addi 

tional initiatives to enhance their abil 

ity to detect lending discrimination, 

to improve the level of education they 

provide to the industry and to their 

examiners, and to strengthen enforce 

ment. 

A number of inter-agency efforts 

are already completed or in prepara 

tion to pursue these objectives. Over 

the next several months the agencies 

are seeking to accomplish the follow 

ing: 

a) The agencies will develop a new 

training program in fair lending for 

experienced compliance examiners 

that will be conducted on a regional 

basis; b) the agencies will develop and 

sponsor regional programs for toplevel industry executives to explain 

the agencies' programs for enforce 

ment and to foster additional sensitiv 

ity and awareness among lenders 

about discrimination issues, specific 

ally subtle practices that impede the 

availability of credit to low-income 

and minority individuals; c) the agen 

cies will explore statistically-based 

discrimination analysis models, to 

help identify loan application files for 

review as part of the examination pro 

cess; d) each agency will implement 

an internal process for making refer 

rals to the Department of Justice for 

violations of the Equal Credit Oppor 

tunity Act; e) each agency will evalu 

ate the effectiveness of its consumer 

complaint system in detecting and 

correcting credit discrimination and 

announce its own specific initiatives 

in these areas. Joint Re/ease, OCC, FDIC, 

FRB, OTS, 6110193. 

Examination Reports 

The four federal bank and thrift 

regulatory agencies have agreed to 

use the same examination report for 

mat for presenting key information 

and conclusions about an institution's 

Qperations. The uniform examina 

tion pages will be used for reporting 

an institution's CAMEL factors: cap 

ital, asset quality, management, earn 

ings and liquidity. Use of the 

common format is intended to reduce 

regulatory burden, make examina 

tions more uniform, and promote con 

sistency in the way institutions are 

supervised. The core information 

will help the regulators communicate 

when they share a supervisory interest 

in an institution. Any agency may add 

additional pages to its report of exami 

nation to adjust to changing needs and 

individual examination requirements. 

Use of the new format is expected to 

begin later this year. FIL-72-93, FDIC, 

10119193; Inter-agency Policy Statement on the Uni 

form Core Report of Examination, 9/9/93, OCC, 

FRB, FDIC, OTS. 

Policy on SmaU-Bminess Loan 

Documentation 

An inter-agency policy statement 

in March 1993 allowed well- or ade 

quately capitalized institutions that 

are composite rated 1 or 2 to identify 

a portion of their portfolios of loans to 

small- and medium-sized businesses 

and farms, subject to certain limita 

tions, to be evaluated solely on perfor 

mance. Those loans would be 

exempt from examiner criticism of 

documentation. Effective im 

mediately, banks that are well- or ad 

equately capitalized and CAMEL 

rated 3, and Federal Branches and 

Agencies that are AIM (assets, inter 

nal control, management) rated 3, will 

be approved as eligible for the pro 

gram on a case-by-case basis. Re 

quests in writing will be approved or 

disapproved based on several factors, 

among which are the quality of board 

and management supervision, asset 

quality, capital adequacy, earnings 

quality and capacity, and compliance 

with laws and regulations. BankingBui

letitt No. 46, OCC, 8/12/93. 

New Procedures for 

Compliance Examinations 

The OCC announced new proce 

dures to improve the quality and fre 

quency of examinations in the 

compliance area, formalizing a sepa 

rate career path for compliance exam

iners, and a two-year cycle for 

compliance examinations for all na 

tional banks. The compliance pro 

gram reviews national banks' 

compliance with laws and regulations, 

including the Community Reinvest 

ment and Fair Lending Acts, con 

sumer regulations, and trust law, 

Under the new examination cycle, 

each national bank will be examined 

every other year, a frequency pre 

viously reserved for banks with assets 

of more than $1 billion. Heretofore, 

smaller banks have been examined 

for compliance only on the basis of 

identified need or random sampling. 

Before the regular two-year cycle be 

gins in January 1997, every bank will 

be examined for compliance at least 

once. 

As part of this program, theOCC's 

six District Offices will be staffed 

with compliance personnel. Each of 

those offices will have a consumer af 

fairs officer responsible for outreach 

to community organizations and the 

public. News Release, OCC, 8/16/93. 

Banks * Retail Sales of 

Nondeposit Investments 

The OCC issued general guide 

lines, effective immediately, for na 

tional banks offering mutual funds, 

annuities and other nondeposit in 

vestments for sale to retail customers 

(see also the FDIC section above). 

Among the numerous topics in 

cluded, banks were advised that to the 

extent permitted by space and per 

sonnel, management should take 

steps to separate the retail deposittaking and retail nondeposit sales 

functions. The agency strongly dis 

courages employees who accept retail 

deposits from selling retail nondeposit investment products. 

Banks may not offer uninsured re 

tail investment products with a prod 

uct name identical to the bank's 

name, and should recognize that use 

of uninsured product names similar to 

the bank's name may be a cause of 

customer confusion. When market 

ing uninsured investments to retail 

customers, itshould be conspicuously 

disclosed that the products offered are 

not FDIC-insured, are not obligations 

of the bank and are not guaranteed by 

the bank, and involve investment 

risks. Banks are advised to obtain a 

signed statement from customers ac 

knowledging such disclosures. Also, 

marketing activities and financial 

48 
Recent Developments 

statements should clearly feature the 

disclosures. 

Banks are expected to determine 

whether a product being recom 

mended is an appropriate investment 

for the customer, and they should en 

sure that sales personnel are properly 

qualified and adequately trained to 

sell all bank-related nondeposit in 

vestment products. Programs must 

be maintained independently to ver 

ify compliance with the specified 

guidelines and other related require 

ments. BBR, 7/26193, p. 107. 

Foreign Treatment of U.S. 

Financial Institutions 

The Omnibus Trade and Compet 

itiveness Act of 1988 requires that a 

quadrennial report on the foreign 

treatment of U.S. financial institu 

tions be submitted to Congress by the 

Department of the Treasury, working 

with other agencies. For preparing 

its next report, due no later than De 

cember 1, 1994, the Treasury asked 

for specific comments on: a) those 

markets that deny national treatment 

to U.S. banking organizations and se 

curities companies in banking and/or 

securities activities; b) the laws, regu 

lations, restrictions, or practices that 

result in the denial of equality of com 

petitive opportunity; c) the serious 

ness of such obstacles to business 

operations; and d) significant denials 

in the provision of "national treat 

ment,"/>., the policy of providing for 

eign financial firms an opportunity to 

compete on an equal basis with local 

domestic firms, since June 30, 1990. 

FR, 9114/93, p. 48088. 

Requirements Affecting 

Lending Eased in Flood 

Areas 

The OCC, FDIC, FRB, the Na 

tional Credit Union Administration 

(NCUA) and the OTS are exempting 

lending institutions in designated 

flood areas from current federal re 

quirements that institutions obtain 

appraisals on real estate pledged as 

collateral for loans. The agencies 

said the exemption is necessary be 

cause the disruption of real-estate 

markets in the flood area interferes 

with the ability of institutions to ob 

tain appraisals that meet the require 

ments of federal law and regulations. 

The exemption extends for three 

years from the date the President de 

clared a major disaster area, and is in 

effect for institutions making loans 

secured by affected real property in 

disaster-designated areas in Illinois, 

Iowa, Kansas, Minnesota, Missouri, Ne 

braska, North Dakota, South Dakota 

and Wisconsin. The order also will 

apply to any other Midwest flood areas 

added to this summer's list by the 

President and published by the Fed 

eral Emergency Management Agency. 

The agencies determined that the 

exceptions would not affect adversely 

the lending institution's safety and 

soundness so long as their records in 

dicate either that the property was 

directly affected by the major disaster 

or that the transaction would facilitate 

recovery from the disaster, and there 

is a bindingcommitmenttofund the loan 

within the three-year period. Joint Release, 

OCC, FDIC, FRB, NCUA, OTS, 8112(93; FR, 

8111, p. 42640. 

Civil Money Penalties 

The OCC adopted a revised policy 

on the assessment of civil money pen 

alties against national banks and 

bank-affiliated persons. Amend 

ments to the Federal Deposit Insur 

ance Act contained in FIRREA gave 

the banking agencies increased au 

thority to assess the penalties. The 

new policy clarifies and details the 

OCC's internal referral and review 

procedures for considering whether to 

recommend a civil money penalty, 

and formalizes procedures already in 

use in many cases. Use of the "CMP 

matrix" developed several years ago 

by FFIEC will continue. The matrix 

contains 13 factors against which the 

actions under scrutiny are measured. 

However, the new policy explicitly 

recognizes that a "reprimand" or "su 

pervisory letter" may be the more ap 

propriate action in some cases. It is 

noted that these lesser sanctions are 

not subject to mandatory public dis 

closure by the agency. Banting Circular 

No. 273, OCC, 6116193; AB, 9!2/93,p, 18. 

Other Real Estate Owned 

The OCC issued a final rule to 

simplify and clarify its requirements 

regarding bank treatment ofother real 

estate owned (OREO). OREO is com 

prised generally of all real estate 

acquired and held by a bank thai is 

not currently in use or contemplated 

for use as bank premises. National 

banks acquire most of their OREO 

through foreclosure or other forms of 

conveyance, and they are permitted 

by statute to hold such assets for up to 

five years. A bank may apply to the 

OCC to hold OREO for up to an 

additional five years, if they have 

made a good-faith effort to dispose of 

the property or the property's disposal 

would be detrimental to the bank. 

The new rule, which is effective Sep 

tember 17,1993, expands the permissi 

ble options available to banks in 

disposing of OREO. FR, 9/2/93, p. 46529; 

Banking Bulletin No. 51, OCC, 9/3/93. 

Bank May Take Delivery of 

Commodities for Hedging 

The OCC gave approval for Mor 

gan Guaranty Trust Co. to physically 

take possession of commodities un 

derlying derivative contracts. Deliv 

ery may be taken only on behalf of a 

customer, and the activity is restricted 

to a "nominal percentage" of the 

bank's total hedging activities. Mor 

gan Guaranty, which has a state char 

ter, had to obtain the OCC's approval 

because banking law restricts state 

bank activities to those allowed na 

tional banks. In part because of the 

large resources required for this activ 

ity, very few banks are likely to seek 

regulatory approval to engage in it, 

analysts said. AB, 10/28/93,p. 5. 

Court Restricts Bank 

Annuity Sales in 

Three States 

A federal appeals court panel in 

Houston, in a case involving a sub 

sidiary of NationsBank Corp., ruled 

that banks cannot sell annuities in 

towns having a population of more 

than 5,000. The ruling would not 

reach beyond the Fifth Circuit, which 

comprises Texas, Louisiana, and 

49 
FDIC Banking Review 

Mississippi, unless the OGC "decides 

to acquiesce nationwide," an observer 

said. 

The court based its decision on a 

finding that annuities are a form of 

insurance. In 1990, the OCG author 

ized annuity sales for national banks, 

stating that while "annuities have his 

torically been a product of insurance 

companies, they are primarily finan 

cial investments." Having found that 

annuities are an insurance product, 

the court concluded that because 

Congress authorized bank insurance 

activities in smaller towns, it prohib 

ited them in larger ones. The coiirt 

also held that annuities are not an 

"incidental power" that can be au 

thorized as being necessary to bank 

ing. 

The Fifth Circuit decision appears 

to conflict with a ruling by the Second 

Circuit Court of Appeals that banks 

can sell insurance nationwide from of 

fices located in towns of less than 

5,000. AB, 8/31193, p. 2. 

Community Development 

Corporations and Project 

Investments 

The OCC proposed a rule for na 

tional bank investments to imple 

ment Section 6 of the Depository 

Institutions Disaster Relief Act of 

1992. National banks would be al 

lowed, under certain conditions, to in 

crease the amount of their aggregate 

and single project investments in 

community development corpora 

tions (CDCs) and community devel 

opment projects above current 

investment limits, with OCC ap 

proval. The OCC's approval process 

would be changed to permit national 

banks to make most CDC and CD 

project investments without prior 

OCC approval by providing a brief 

self-certification of compliance with 

the rule. FR, 7/16/93,p. 38474. 

Office of Thrift Supervision 

Regulatory Capital 

Interest-Rate Risk Component 

The OTS adopted a regulation 

pursuant to a provision of FDICIA 

which mandates that all federal bank 

ing agencies' risk-based capital regu 

lations address interest-rate risk. 

Under the new regulation, thrifts that 

have normal levels of interest-rate risk 

(IRR) will have lower capital require 

ments than institutions with abovenormal IRR. Those high-risk 

associations will either have to re 

structure their portfolios to reduce 

their interest-rate risk or hold addi 

tional capital as a cushion against the 

risk. The regulation culminates five 

years of OTS' efforts to improve the 

monitoring and supervision of IRR. 

The OTS model evaluates data 

supplied by savings institutions in 

their quarterly Thrift Financial Re 

ports. Each quarter, the model gen 

erates exposure reports that provide 

each institution with OTS' estimate 

of the interest-rate sensitivity of the 

institution's assets, liabilities, and offbalance-sheet items. The reports 

show the effect of nine hypothetical 

scenarios in which interest rates move 

up or down. The result is a measure 

of the sensitivity of an institution's 

"net portfolio value" to changes in 

interest rates. Net portfolio value is 

the difference between incoming and 

outgoing discounted cash flows from 

assets, liabilities, and off-balance

sheet contracts. Each institution's 

IRR is measured by the change that 

occurs to its net portfolio value as a 

result of a hypothetical two percent 

age point increase or decrease in mar 

ket interest rates (whichever leads to 

the lower net portfolio value). A 

"normal level" of IRR is any decline 

in net portfolio value of up to two 

percent of the institution's assets. 

Institutions will be required to hold 

capital against IRR only when their 

risk exceeds the two percent thresh 

old. Beyond that point, the amount 

of capital required against IRR will be 

one-half of the difference between 

the measured risk and two percent of 

assets. 

Consistent with an agreement 

among the federal banking agencies, 

the OTS expects to lower the mini 

mum leverage ratio requirement, now 

four percent, once the IRR compo 

nent is incorporated into the riskbased capital requirement. July 1, 

1994 will be the first time that thrifts 

will be required to incorporate IRR in 

their capital calculations. The calcu 

lations will be based on institutions' 

financial data as of December 31, 

1993. 

The final rule exempts small, 

highly capitalized institutions from 

filing Schedule CMR (IRR compo 

nent reporting form), and thus these 

institutions are not subject to the IRR 

component. To qualify for the ex 

emption, an association must have 

less than $300 million in assets and a 

risk-based capital ratio in excess of 12 

percent. The OTS retains the dis 

cretion to require any exempt institu 

tion to file Schedule CMR if there is 

a reason to be concerned about their 

IRR exposure. Under certain cir 

cumstances, the OTS director may 

waive or defer an institution's IRR 

capital requirement, if, for example, 

the institution has taken meaningful 

steps to reduce or control its exposure 

that have not yet been reflected in its 

Thrift Financial Report. 

At a later date, the OTS plans to 

release guidelines outlining an ap 

peals process that will be available 

under certain circumstances to thrifts 

that disagree with OTS' estimate of 

their IRR exposure. On a case-by

case basis, the OTS will allow thrifts 

to use the results from their own 

model, rather than the OTS model. 

Also, once the IRR rule is effective, 

certain mortgage-backed securities 

that are currently in the 100 percent 

risk-weight category will be moved to 

lower credit risk-weighting catego 

ries, NEWS, OTS, 8/23/93; FR, 8/31,p. 45799; 

"Questions and Answers on the Interest-Rate Risk 

Component," OTS, 8/93. 

Mutual Holding Companies 

Mutual savings and loans are per 

mitted to create a new type of corpo 

rate structure, the mutual holding 

company, under a regulation adopted 

by the OTS, effective September 20, 

1993. Mutual holding companies 

were first authorized by the Compet 

itive Equality Banking Act of 1987 

(CEBA). In a mutual holding com 

pany structure, depositors, and in 

some cases borrowers, own the hold

50 
Recent Developments 

ing company which, in turn, holds a 

majority of voting stock of its subsid 

iary savings association. The balance 

of the thrift's stock can be sold to 

outside investors to raise capital. In 

contrast to a traditional savings and 

loan conversion from a mutual to 

stock ownership, in which all of the 

thrift's stock must be offered to de 

positors and the public at once, under 

a mutual holding company the thrift's 

stock can be sold in batches as market 

conditions warrant. Also, mutual 

holding companies can acquire sub 

sidiaries, including other thrift insti 

tutions and some other types of 

companies. 

The final rule requires minority 

stock issuances to include a priority 

structure which shows the relative 

rights of various groups such as depos 

itors, borrowers and the institution's 

employee benefit plans to purchase 

stock. The final rule also includes 

safeguards to prevent insider abuse, 

including limitations of the amount of 

stock that can be purchased by insid 

ers and a mandatory independent ap 

praisal of the value of stock offered for 

sale. 

The regulation establishes a for 

mal application process and standards 

under which current mutual savings 

and loans can convert to the mutual 

holding company structure, or new 

institutions can start out under that 

structure. Current stock thrifts can 

not convert to mutual holding compa 

nies. NEWS, OTS, 8/18/93;FR, 8/19,p. 44105. 

More Thrifts Eligiblefor 

Reduced Loan 

Documentation 

The OTS took another step, effec 

tive immediately, to expand the avail 

ability of credit, giving additional 

savings institutions the opportunity to 

make "character loans" that are not 

required to have all of the regulatorymandated documentation. The action 

extends to certain MACRO 3 rated in 

stitutions a policy announced by OTS 

and the other federal financial regula 

tory agencies in March 1993, which 

said well-run, well- or adequately cap 

italized institutions—those receiving 

MACRO 1 or 2 ratings could make 

a limited amount of loans that would 

not be criticized by OTS examiners 

for not having all the usually required 

documentation. Once approved, 

MACRO 3 institutions, like their 

MACRO 1 and 2 counterparts, will 

decide the appropriate level of docu 

mentation for such things as sources 

of income and the credit history of the 

borrower. The reduced documenta 

tion will cut costs to the lender, and 

the time required to respond to credit 

applications. 

The total of all loans in this special 

category may not exceed 20 percent 

of an institution's total capital, and 

loans to any one borrower in the spe 

cial category are limited to the lesser 

of $900,000 or three percent of the 

thrift's total capital. Loans to insid 

ers and loans that are already de 

linquent do not qualify for this 

exemption. NEWS, OTS, 9/14193. 

Sales ofSecurities at Savings 

Association Offices 

Amendments published by the 

OTS in October 1992 prohibit sales of 

the securities of a savings association 

or its affiliates in any office of the 

association except for sales of stock in 

connection with the association's con 

version from the mutual to the stock 

form of organization, and subject to 

certain conditions. The agency has 

clarified that other limited exceptions 

are permitted. For example, the 

OTS does not consider the sales pro 

hibitions to be applicable to initial 

stock offerings of an association that is 

held by a mutual holding company. 

These offerings will be treated the 

same as mutual to stock conversions. 

Further guidance is provided on 

what directors and managers should 

do to ensure that permitted offers and 

sales are conducted in a safe-and

sound manner. Some of the safe 

guards are: a) establishing a training 

program for employees selling the se 

curities; b) establishing minimum 

qualifications for retail sellers; c) 

adopting procedures to assure that 

sellers do not supplement written of 

fering materials with information that 

misstates material facts; d) designat 

ing an officer to be responsible for 

coordinating and supervising the 

association's compliance with its es 

tablished safeguards; and e) ensuring 

that customers sign the required ac 

knowledgement form regarding their 

understanding that the security they 

are purchasing is not an insured ac 

count. Thrift Bulletin 23a, OTS, 6123/93. 

Guidance on Uninsured 

Thrift Products 

The OTS is reemphasizing to sav 

ings associations selling uninsured 

products, including mutual funds and 

insurance annuities, that they must 

conform to federal rules designed to 

protect depositors from being misin 

formed or misled about the nature of 

these products. The agency's rules 

on selling uninsured products apply 

not only when they are sold on savings 

association premises, but also at any 

other location when the sale is the 

result of an association referral. 

In general, OTS rules require that 

all sales of mutual funds or other un 

insured products take place in an area 

segregated from the area where 

deposits are taken. The agency 

strongly encourages that customers 

be advised of and acknowledge 

awareness of the risks involved and 

that the investment is not FDICinsured by signing a brief. Every re 

ferral should alert the customer to the 

fact that the investment products are 

not guaranteed by the association and 

are not federally insured. Any refer 

ral fees paid to association employees 

should be nominal and should not be 

dependent on a sale being made. Sav 

ings associations should adopt a policy 

governing customer referrals and the 

release of customer information. NEWS, 

OTS, 9/7/93; Thrift Bulletin 23-1.9/1. 

Accounting Policyfor Troubled 

Loans 

Under OTS' new policy, effective 

September 30, 1993, savings associa 

tions should carry certain troubled, 

collateral-dependent loans at present 

value, discounted at the loan's con 

tractual interest rate. In current 

practice the discount rate could be the 

savings association's cost of capital 

rate, which generally results in a 

SI 
FDIC Banking Review 

higher carrying value for the loan. 

The new policy is consistent with the 

statutory requirement that regula 

tions and policies governing the oper 

ations of savings associations be no 

less stringent than those established 

by the OCG for national banks. The 

policy applies to any troubled, collat 

eral-dependent loan where collection 

in full is not probable. For such a 

loan, any excess of the loan balance 

over the present value should be clas 

sified "loss." NEWS, OTS, 911193; Regula 

tory Bulletin 31,8126193. 

Policy Change Proposedfar 

"Special Mention "Assets 

The OTS proposed to remove the 

"special mention" designation for as 

sets from its regulations, and issue a 

guidance on when thrift institutions 

should designate an asset as special 

mention. Special mention is in 

tended to identify assets not yet war 

ranting an adverse classification, but 

that, nonetheless, possess credit defi 

ciencies or potential weaknesses 

deserving close attention, NEWS, OTS, 

7/20193; FR, 7/20, p. 38730. 

Notice Requiredfor Changing 

or Adding Officials 

The OTS adopted a final regula 

tion that codifies the agency's existing 

requirement that before adding any 

individual to its board of directors or 

employing a new senior officer, a sav 

ings association that is either new or 

troubled must give OTS 30 days' no 

tice. Although the regulation is ef 

fective September 29, 1993, affected 

savings associations and holding com 

panies have been subject to the noti 

fication requirement and disapproval 

provisions since August 9,1989, when 

FIRREA was enacted. The OTS 

rule is the result of a cooperative effort 

with the other federal banking agen 

cies to ensure comparability. 

During the 30-day period, OTS 

reviews the competence, experience, 

character and integrity of the nomin 

ees, and may disapprove their ap 

pointment if the appointment is 

contrary to the best interests of the 

depositors or the public. The rule ap 

plies to savings institutions that are 

less than two years old (unless they 

operated previously under a different 

charter), institutions that fail capital 

requirements, receive adverse exami 

nation ratings, or are otherwise trou 

bled, and institutions or their holding 

companies that have undergone a 

change in control during the past two 

years. The rule also applies to sav 

ings and loan holding companies that 

are in a troubled condition. NEWS, OTS, 

8/27/93; FR, 8/30, p. 45421. 

Outreach Programfor 

Participation in Contracting 

Activities 

OTS is adopting a Minority-, 

Women- and Individuals With Dis 

abilities-Owned Business Contract 

ing Outreach Program, as required by 

FIRREA. The final rule, effective 

July 19, 1993, is intended to ensure 

that business concerns owned and 

controlled by persons in the above 

groups are provided the opportunity 

to participate in OTS' contracting 

programs. It also designates the offi 

cial responsible for implementing the 

program and its oversight. The rule 

includes defining minority-, women-, 

and individuals with disabilitiesowned firms capable of providing 

goods and services to the OTS; the 

agency's official policy; certification 

of identified firms; promotion of the 

program; guidelines for the solicita 

tion of contracts that promote partici 

pation in OTS' contracting; and the 

oversight and monitoring of the pro 

gram. FR, 6/17/93, p. 33323. 

Affordable Housing, Fair 

Lending Programs 

The OTS will initiate a program 

for increasing the flow of credit to lowand moderate-income and minority 

applicants. The five OTS regional 

offices will direct and manage the 

community outreach efforts, and pro 

vide technical assistance to OTS ex 

aminers and other staff on CRA and 

related issues. Community liaisons 

will be created in the regions to work 

with consumer and community 

groups and government and industry 

organizations. A newly created posi 

tion in each region will supervise its 

compliance examination function and 

staff handlingof consumer complaints 

against regulated institutions. A 

headquarters office will develop and 

disseminate national policy on CRA 

issues, and work with community 

organizations at the national level. 

NEWS, OTS, 10/20/93. 

Guidelines to Help Midwest 

Flood Rebuilding 

Savings and loan associations in 

states hit by flooding are being urged 

to reach out to their communities and 

work with borrowers to finance re 

building. OTS will grant temporary 

waivers of some rules to help savings 

institutions cope with the disaster. 

Thrifts also are urged to work with 

borrowers to restructure or to increase 

their loans if needed to finance recon 

struction or repair, to consider tempo 

rarily waiving charges for late 

payments for flood victims, and to 

seek out various government pro 

grams that may help in cases in which 

credit riskof potential borrowers is too 

great. NEWS, OTS, 1/14/93. 

Supervisory Appeals Process 

Modified 

The OTS has revised its examina 

tion procedures to modify the appeals 

process and enhance feedback from 

the institutions it supervises. The 

program aims to make senior regional 

examination officials more accessible 

to thrift management, improve exam 

ination quality and better resolve ex 

amination-related disagreements. 

The agency has appointed senior staff 

members in each of its five regions 

who will visit thrifts regularly to dis 

cuss examination procedures and re 

sults with thrift management as well 

as to solicit ideas for improving the 

examination process. The examina 

tion oversight managers will review 

examination reports for content, per 

spective, uniformity, tone and confor

mance with national policy and 

guidelines. 

The program is one of sv, eral steps 

taken by the OTS in line with Presi 

dent Clinton's initiatives to encour 

age thrifts and banks to make more, 

sound loans to consumers and smalland medium-sized businesses. NEWS, 

OTS, 7/16/93. 

52 
Recent Developments 

Federal Financial Institutions 

Examination Council 

Regulatory Treatment of 

Securities Portfolios 

The FFIEC announced that all 

federally supervised banks and sav 

ings associations should adopt the 

Statement recently issued by the Fi 

nancial Accounting Standards Board 

(FASB) for regulatory reporting pur 

poses no later than January 1,1994, or 

the beginning of their first fiscal year 

thereafter. The FFIEC said con 

forming changes will be made to the 

Reports of Condition and Income. 

The OTS already has made appropri 

ate changes to the Thrift Financial 

Report. 

This new accounting standard pro 

vides that for financial reporting pur 

poses, depository institutions should 

divide their securities holdings 

among three categories: held-to-ma

turity, available-for-sale, and trading 

securities. The held-to-maturity cat 

egory supplants the current held-for

investment category, but the 

accounting basis remains the same. 

Only those debt securities for which 

an institution has the positive intent 

and ability to hold to maturity may be 

included in the held-to-maturity ac 

count, and the institution would con 

tinue to account for these debt 

securities at amortized cost. 

The accounting treatment for trad

ing securities has not changed. 

Trading securities are those debt and 

equity securities that an institution 

buys and holds principally for the pur 

pose of selling in the near term. 

Trading securities will continue to be 

reported at fair value (i.e., generally 

market value), with unrealized 

changes in value reported directly in 

the income statement as a part of the 

institution's earnings. 

For many institutions, the avail 

able-for-sale category will include a 

larger amount of securities than the 

current held-for-sale category it re 

places. Securities in the availablefor-sale category are defined as those 

securities for which the institution 

does not have the positive intent and 

ability to hold to maturity, yet does 

not intend to trade actively as part of 

its trading account. While held-for

sale securities have been carried at the 

lower of cost or fair value> with the 

offsetting entry reported directly in 

the income statement, available-for

sale securities must be reported at fair 

value. Any unrealized appreciation or 

depreciation in the value of debt and 

equity securities available for sale are 

to be reported directly as a separate 

component of equity capital, and thus 

will have no effect on the reported 

earnings of the institution. Press Re/ease, 

FFIEC, 81'10193. 

State Certification of 

ReaUEstate Appraisers 

The Appraisal Subcommittee 

(ASC) of the FFIEC issued Policy 

Statements to assist the states in de 

veloping regulatory structures for cer 

tifying, licensing and supervising 

real-estate appraisers. Title XI of 

FIRREA requires, among other 

things, that the ASC maintain a na 

tional registry of state-licensed and 

-certified appraisers, and ensure that 

each state appraiser certifying and li 

censing agency transmits to the ASC 

a roster of eligible appraisers to per 

form appraisals in federally related 

transactions, along with an annual reg 

istry fee. The Statements reflect the 

general framework that the ASC is 

using to review a state's program, and 

there are new interpretations particu 

larly regarding appraiser qualifications, 

temporary practice, a national regis 

try, and enforcement. "Policy Statements 

Regarding State Certification and'Licensing ofRea/

Estate Appraisers," ASC, FFIEC, 814/93; BBR, 

8130, p. 323. 

Mortgage Lending Reportsfor 

1992 Now Available 

Data on mortgage lending transac 

tions in 1992 are now available to the 

public in metropolitan areas through 

out the nation. This information, in 

the form of individual disclosure 

statements, summarizes the mortgage 

lending activities of more than 9,000 

lenders covered by HMDA. The 

FFIEC prepared the HMDA state 

ments on behalf of its member agen 

cies and the U.S. Department of 

Housing and Urban Development. 

Beginning this year, lenders are re 

quired to make the reports available, 

upon request, at their home offices 

within three business days of receiv 

ing the reports, and within ten busi 

ness days at certain branch offices in 

other metropolitan areas. In prior 

years, they could wait 30 calendar 

days before releasing the statements 

to the public. 

The HMDA reports cover both 

home purchase and home improve 

ment loans. They contain informa 

tion about loan originations, loan 

purchases, and applications that did 

not result in a loan. For property in 

metropolitan areas, they identify the 

geographic location (generally by cen 

sus tract). They also give informa 

tion about three characteristics of 

applicants or borrowers: sex, race or 

national origin, and annual income. 

For 1992, the reports present data on 

nearly 12 million records, an increase 

of about 33 percent from 1991. Pms Re 

lease, FFIEC. 815193. 

National Credit Union 

Administra tion 

Field ofMembership and 

Chartering Policy 

The NCUA proposed an interpre 

tive ruling and policy statement up 

dating the agency's field of 

membership and chartering policy for 

federal credit unions. The proposed 

changes in part are designed to: a) 

facilitate corporate and military unit 

restructurings; and b) clarify NCUA 

policy on the "operational area" re 

quirement for select group expan 

sions. 

The NCUA noted that the restruc 

turings taking place in many organi 

zations served by credit unions have 

forced credit union officials to adapt 

quickly to significant changes to their 

fields of membership. Sponsoring 

organizations previously organized on 

geographic or military services lines, 

for example, are reorganizing more 

strictly on functional lines. Military 

bases and industrial plants are clos 

ing, leaving credit unions effectively 

without a field of membership. 

53 
FDIC Banking Review 

Technology has expanded the geo 

graphic range within which many 

credit unions can effectively serve 

their members at the same time that 

much of the public have begun to 

demand the convenient service that 

the new technology offers. Those 

seeking to provide credit union ser 

vice to low-income communities have 

shown they need more flexibility in 

the chartering and field of member 

ship expansion process if these credit 

unions are to be effective in helping 

persons of small means obtain a 

source of credit in which they have a 

real voice. FR, 7/28/$>3,p, 40470;8/II,p. 42698. 

NonHsk Asset and Business 

Loan Regulations 

The NCUA issued final amend 

ments, effective July 27, 1993, to: a) 

extend the maturity date of certain 

investments not considered risk as 

sets from three to five years; b) in 

crease the dollar value from$25,000 to 

$50,000 for determining when loans 

are subject to the business loan regu 

lation; c) make the record keeping re 

quirements for business loans 

consistent with the definition of 

member business loans; and d) raise 

the de minimus amount for an appraisal 

performed by a state-chartered or 

-licensed appraiser from $50,000 to 

$100,000. The agency believes 

these changes will decrease 

paperwork requirements and regula 

tory burden without any effect on 

safety and soundness. FR, 7127193, 

p. 40040. 

Investment and Deposit 

Activities 

The NGUA issued a final rule, ef 

fective July 30, 1993, that revises its 

high-risk for Collateralized Mortgage 

Obligations (CMOs) and Real-Estate 

Mortgage Investment Conduits 

(REMICs). GMOs and REMICs 

will be subject to an average life test, 

an average life sensitivity test, and a 

price sensitivity test. A floating-rate 

GMO or REMIC will be subject also 

to the price sensitivity test if it reaches 

its contractual cap at the time of pur 

chase or on a subsequent testing date. 

The revised test is generally consis 

tent with the FFIEC's High-Risk Se 

curities Test for mortgage derivatives, 

which applies to other depository in 

stitutions. FR, 6130193, p. 34868. 

Trutk-in-Savings 

The NGUA issued a new regula 

tion to implement the Truth-in-Sav 

ings Act (TISA). All federal credit 

unions, federally insured state-char 

tered credit unions, and nonfederally 

insured credit unions are required to 

disclose fees, dividend (or interest, if 

applicable) rates and other terms con 

cerning accounts to members or 

potential members before they open 

accounts. Credit unions that provide 

periodic statements to members must 

disclose this information, including 

annual percentage yields, on those 

statements. Substantive limitations 

are imposed on the methods used by 

credit unions to determine the bal 

ance on which dividends are calcu 

lated. The agency's proposal, which 

was issued in November 1992, would 

have permitted credit unions to use 

the daily balance, average daily bal 

ance, rollback, or par value dividend 

calculation methods. The final rule 

allows only the daily balance and av 

erage daily balance methods. Rules 

dealing with advertisements for ac 

counts are included also in the law and 

the regulation. The regulation is ef 

fective January 1, 1995, except for 

some requirements not effective until 

approved by the Office of Manage 

ment and Budget. FR, 9127193,p. 50394. 

Court Upholds Credit Union 

Expansion 

A federal judge in Grand Rapids, 

Michigan denied plaintiff banks' 

claim that the NCUA acted incor 

rectly in approving a charter that 

expanded the membership base of 

Portland Federal Credit Union in 

Ionia County. The 9,000-member 

credit union's field of membership 

would increase from a geographic area 

with a population of 16,000 to an area 

of over 47,000. The plaintiffs con 

tended that on the basis of the differ 

ent area codes and political 

jurisdictions and other evidence, 

there was no common bond. How 

ever, the court accepted the NCUA's 

Finding that the approximately 75,000 

people of the rural county did view 

themselves as a distinct community. 

AB, 8/30/93, p./. 

Voluntary Liquidation of 

Credit Unions 

The NGUA is updating and stream 

lining the minimal procedures for vol 

untary liquidations of federal credit 

unions, effective August 2,1993. The 

final rule will assist a federal credit 

union's officials in the orderly dissolu 

tion of the institution and provide the 

NCUA with sufficient information to 

monitor the process and avoid losses 

to the National Credit Union Share 

Insurance Fund. It requires, among 

other things, the development of a 

written liquidation plan, with a oneyear period for completing the liqui 

dation, expands the notification to 

creditors requirement for federal credit 

unions with more than $500,000 in as 

sets, and eliminates certain reporting 

requirements. For federally insured 

state credit unions, this rule only re 

quires notification, with minimal 

reporting, to NCUA when the deci 

sion to voluntarily liquidate is made. 

FR, 711/93, p. 35363, 

Federal Housing Finance Board 

Advances to CapitalDeficient Members 

The FHFB proposed to amend its 

regulations to incorporate require 

ments governing secured loans (ad 

vances) made by the Federal Home 

Loan Banks to capital-deficient mem 

bers. The Banks would be prohib 

ited from lending to tangibly 

insolvent members, except at the re 

quest of the appropriate federal regu 

lator or insurer. They would be 

restricted from lending to other capi 

tal-deficient members whose use of 

Bank advances has been prohibited 

by the appropriate federal regulator or 

insurer. Each bank would be re 

quired to report monthly to FHFB on 

all outstanding advances and commit 

ments to all members. Rules would 

be provided for the calculation of 

"tangible capital" for these purposes 

54 
Recent Developments 

generally parallel to FDIC "prompt 

corrective action" rules. FR, 9123193, 

p. 49446; Regulatory Alert, Michigan Bankers As 

sociation, 101'18, p. 2. 

State Legislation and 

Regulation 

Interstate Banking 

North Carolina: new law provides 

for the phaseout of regional interstate 

. banking over a three-year period, to 

be replaced by nationwide interstate 

banking. BBR, 7/12/93,p, 49, 

(9/^o»:Areciprocal interstate branch 

ing law enacted earlier this year became 

effective July 1. Alaska enacted legis 

lation that will take effect in January 

1994. AB, 7/12/93, p. 8. 

Intrastate Banking 

Illinois: The Governor signed leg 

islation, effective immediately, end 

ing restrictions on statewide 

branching. All numeric, geographic 

and home office protection branching 

restrictions applicable to statechartered banks are removed, putting 

state banks on the same basis as na 

tional banks. Illinois Banker, 9/93, p. 18; 

Northwestern Financial Review, 9/16/93, p. 15. 

Michigan: Banks are authorized 

under a new law to operate mobile 

branches, and to own or operate mes 

senger-service firms. General Bulletin, 

Michigan Bankers Association, 7/26/93. 

Minnesota: Customers can conduct 

transactions at different banks using 

the same account under a new law, 

effective September 1, 1993, which 

allows banks to contract with each other 

for services. An organization with two 

or more banks under common owner 

ship could be operated with functional 

similarity to a branching system under 

the Statute. Northwestern Financial Review, 

9/4/93, p. 29. 

A recently enacted bank merger 

and consolidation law, effective Au 

gust 1,1993, removed the limit on the 

number of detached facilities a bank 

may have in the state. The limit al 

ready had been taken off for the Twin 

Cities metropolitan area. There was 

no change in the number of de novo 

offices permitted for a bank in the 

State, Which is five. Northwestern Financial 

Review, 9/18/93, p. 31, 

Innocent Landowner Defense 

Illinois: Amendments to the Envi 

ronmental Protection Act establish a 

uniform standard of "due diligence" 

or "appropriate inquiry" necessary for 

lenders and other defendants to sat 

isfy the Innocent Landowner Defense 

under present Illinois Superfund laws. 

It creates a "rebuttable presumption" 

of innocence when such action is taken 

by defendants. It further establishes 

a "safe harbor" from environmental 

clean-up costs for innocent individ 

ual, single-family residential property 

Owners. Illinois Banker, 9/93, p. 18. 

Power to Sell Annuities 

Maine: New legislation authorizes 

licensed financial institutions, credit 

unions, holding companies, and their 

employees and subsidiaries to sell an 

nuities directly or through contracts 

with licensed third parties. 

Nevada: Under a new law, banks are 

allowed to sell annuities following the 

Financial Institutions Commissioner's 

issuance of a license for such sales. BBR, 

8/2/93^,171, 

Compliance Review 

Information Protected 

Mary/and: A law that becomes ef 

fective in October 1993 will protect 

bank compliance review information 

from being subpoenaed in civil cases. 

Under the law, internal bank informa 

tion from compliance review commit 

tees is "confidential and is not 

discoverable or admissible in evi 

dence in any civil action." The law 

applies to all federal or state-char 

tered commercial banks, savings and 

loan associations, and credit unions in 

the state. AB, 9/3/93,p. 7. 

CRA Requirements 

New York: The State Banking 

Board proposed a revised regulation, 

implementing the Community Rein 

vestment Act, that would use objec 

tive, quantitative data to calculate a 

preliminary CRA rating for a super 

vised bank. This analysis would be 

followed by a qualitative analysis 

which could result in an upward or 

downward revision in the quantitative 

rating. The 1-4 rating system now in 

use would continue. Such factors as 

the size of the institution, its financial 

condition, and CRA opportunities in 

the market served and its demo 

graphic characteristics, would be 

taken into account. Community 

banks would not be subject to the 

quantitative analysis. Also, a "safe 

harbor" provision would protect 

banks with three or more consecutive 

"outstanding" or "1" CRA ratings 

from protests in the course of regula 

tory applications. BBR, 10/18/93, p. 590; 

AB, 10/20, p. 8. 

Deregulation ofConsumer 

Loan Rates 

New York: The deregulation of in 

terest rates for consumer credit has 

been extended through January 1994. 

An earlier report by the New York 

State Banking Department said that 

deregulation of the rates in the state 

has improved the availability of 

credit, increased maximum credit 

lines, and has helped strengthen 

banks' capital by improving the prof 

itability of consumer loans. The fact 

that permanent legislation was not 

enacted resulted partly from a lack of 

an agreement on consumer safe 

guards to be contained in the bill. 

BBR, 1/18/93, p. 59; 7/12, p. 49. 

Mutual Holding Companies 

New York: State-chartered mutual 

savings and loan associations are per 

mitted to form mutual holding com 

panies under recently enacted 

legislation. The mutual holding 

company structure provides a means 

of raising capital, and on an incremen 

tal basis. Also, it enables an institu 

tion to retain its community-based 

nature. BBR, 8/2/93,p. 170. 

Selling ofAnnuities 

New York:T\\t state supreme court 

held that the New York State Banking 

Department may authorize state-char 

tered banks under the "incidental 

powers" clause in the state banking 

law to sell annuity contracts as agents 

for insurance companies. A lowercourt ruling had prohibited state-char 

tered banks from brokering fixed-and 

variable-rate annuities. BBR, 6/21/93, 

p. 927. 

55 
FDIC Banking Review 

Small'Business Loan Program 

New York: new law authorizes the 

state to deposit up to $100 million in 

general funds or public corporation 

funds in commercial banks that will 

make loans to small- and mediumsized businesses. The loan rates will 

be 200 to 300 basis points below mar 

ket rates, and the state receives a lower 

return on its deposits. BBR, 8123193, 

p. 282, 

Supervision ofForeign Banks 

New York; The Governor signed 

legislation that greatly enhances the 

state's ability to monitor foreign 

banks and handle their liquidations. 

It parallels similar but more general 

federal legislation. The law autho 

rizes the New York State Banking De 

partment to examine transactions by 

employees in the state on behalf of 

any office of the foreign parent bank, 

expands the grounds for revoking or 

suspending foreign bank licenses, and 

requires foreign bank offices in the 

state to provide prompt notification of 

any change in control. Among other 

provisions are: foreign banks are re 

quired to pledge funds.for covering 

expenses involved in a liquidation; 

and offices of foreign banks in the 

state are subject to state restrictions 

on the amount of single-borrower 

loans. AB, 812193, p. 2. 

Conversions to State Charters 

Okfa/toma:Th& Banking Board ap 

proved new standards for national 

banks applying to convert to state 

charters. Consideration for conver 

sion is limited to banks that, upon 

examination and investigation by the 

Banking Department: a) receive a 

uniform financial institutions rating of 

a composite 1 or 2 (in a scale of 5), and 

b) would not be subject to supervisory 

action by the department, such as a 

memorandum of understanding or 

cease and desist order. The Board 

approved the standards as an emer 

gency rule, requiring the Governor's 

signature before becoming effective, 

and also as a permanent rule which 

must await legislative action next year 

to become effective. Oklahoma Banker, 

1011193, p. 2. 

Tax Incentivesfor Investment 

South Dakota: new law, effective 

immediately, provides for reductions 

in the franchise tax for a six-year pe 

riod for banks that invest in firms that 

buy part ownership in new or existing 

businesses. Northwestern Financial Review, 

413193, p. 30. 

Banking Structure Laws 

Texas: new law, effective August 

30, 1993, allows mergers, reorganiza 

tions, and conversions involving state 

and federal savings banks, state and 

federal savings and loan associations, 

and state commercial banks. 

Another law, to take effect on the 

same date, provides for the establish 

ment and regulation of state-char 

tered savings banks that can engage in 

lending and investing activities sim 

ilar to those presently permitted for 

state-chartered thrifts. State or fed 

eral commercial banks, savings and 

loan association, and federal savings 

banks are allowed to convert to statechartered savings banks after ap 

proval by the Savings and Loan 

Commissioner. BBR, 715193, p. 20. 

Money Laundering 

Texas: Under a first-of-ks-kind 

agreement, state enforcement offi 

cials will have direct on-line access to 

the U.S. Treasury Department's 

database of currency transactions in 

excess of $10,000 that is constructed 

from records provided by financial in 

stitutions. new law, effective Sep 

tember 1, 1993, expanded the state 

attorney general's anti-money-launder 

ing enforcement powers. BBR, 7/i2/93,p. 50. 

Environmental liability 

Vermont: Under a recently enacted 

law, a lender or fiduciary will not be 

liable as owner and operator if it 

requires or conducts, after receiving 

state approval, an investigation and 

removal activities in response to a 

release or threatened release of haz 

ardous materials. The law allows 

lenders to clean up foreclosed prop 

erty under agreement with the state 

that limits liability to the property's 

fair value or an amount agreed to 

under the plan. BBR, 6121193,p. 920. 

Bank and Thrift Performance 

Insured Institutions Had 

Strong Third Quarter 

FDIC-insured commercial banks 

earned nearly $11.5 billion (prelimi 

nary) in the third quarter of 1993, up 

from $10.4 billion (preliminary) in the 

second quarter. Third-quarter net 

income surpassed the record set in the 

first quarter, when one-time account 

ing gains contributed more than $1,5 

billion. For the first nine months of 

1993, commercial banks earned $32.6 

billion, an increase of $8.5 billion over 

the same period a year ago, and $500 

million above the net income for the 

full year 1992. 

Lower loan-loss provisioning, re 

flecting improved credit quality, and 

increased noninterest income pro 

vided most of the increase in earnings 

in the quarter. Net interest income 

increased by $416 million. The 

industry's average net interest margin 

has declined for three consecutive 

quarters to 4.45 percent, from the re 

cord 4.67 percent registered in the 

fourth quarter of last year. The com 

position of bank liabilities continues 

to shift away from costlier, longerterm certificates of deposit, into noninterest-bearing demand deposits, 

lower-rate savings deposits, and shortmaturity liabilities such as overnight 

borrowings. Also, increased levels of 

equity capital tend to reduce the need 

for interest-bearing liabilities. Ex 

cluding nonrecurring items, commer 

cial banks' core net operating income 

has increased in each of the last seven 

quarters. Fewerthan one in 20 banks 

lost money in the quarter or in the first 

nine months of the year, the lowest 

percentage in the ten years since 

quarterly income reporting began. 

The decline in troubled assets that 

began two years ago continued in the 

third quarter. Noncurrent loans, 

which fell by $4 billion, were lower 

in all regions. The greatest im 

provements were at banks with the 

highest overall levels of troubled 

assets those in the Northeast and 

West regions, and in the largest assetsize groups. Noncurrent loan levels 

improved in all major loan categories, 

56 
Recenc Development 

even as net charge-offs declined. 

Troubled assets noncurrent loans 

plus foreclosed property are now at 

their lowest level since the first quar 

ter of 1989, and represent the lowest 

ratio to total assets since the fourth 

quarter of 1986. 

Commercial banks' total assets in 

creased by $62 billion in the third 

quarter, the largest quarterly rise 

since the last quarter of 1989. While 

the growth in bank assets occurred in 

all regions, the gains were largest out 

side the West and Northeast regions. 

Nationally, the strong growth in non 

commercial loans (l-to-4 family resi 

dential mortgages and consumer 

loans), investment securities and trad 

ing-account assets accounted for most 

of the increase. Commercial and in 

dustrial loans outstanding fell by $5.3 

billion, to $529.7 billion, the lowest 

level since the end of 1983. 

FDIC-insured savings institutions 

earned $1.2 billion (preliminary) in 

the third quarter of 1993, the eighth 

consecutive quarter of positive earn 

ings. Favorable interest rates and 

declining inventories of troubled as 

sets enabled most savings institutions 

to be profitable. Net interest mar 

gins had been rising for two years 

through the first quarter of 1993, 

when they reached 3.58 percent, but 

declined to an average 3.44 percent 

during the third quarter. Ninetyfour percent of the institutions had 

positive net income in the quarter. 

In the first three quarters of 1993 

earnings totaled $5.3 billion. Of the 

ten largest U.S. savings institutions, 

eight are based in California and four 

of these reported losses during the 

first three quarters of 1993. 

At the end of September 1993, 

there were 2,297 savings institutions 

(excluding RTC conservatorships), 

the number having declined from 

3,704 in the second quarter of 1986. 

Since then over 1,100 institutions 

have failed and numerous others have 

been absorbed or have converted to 

commercial bank charters. The 

RTC has taken control of 741 savings 

institutions since its inception in 

1989. Assets of FDIC-insured sav 

ings institutions have declined from 

the fourth quarter of 1988 by more 

than one-third to $1 trillion at the end 

of September 1993. The decline in 

assets has leveled off recently, and in 

the third quarter total assets in 

creased. The $2 billion increase in 

assets in the quarter reflects primarily 

an increase in their securities hold 

ings, including mortgage-backed se 

curities. Due in large part to the 

removal of many undercapitalized in 

stitutions, average equity capital of 

savings institutions rose from 4.11 

percent of assets at the end of 1988 to 

7.76 percent at September 30, 1993. 

Savings institutions' core capital, or 

leverage ratio, stood at 7.42 percent at 

the end of September. Troubled as 

sets continued to decline for savings 

institutions. Their noncurrent assets 

and other real estate owned (OREO) 

were 2.43 percent of assets. Realestate problems persist in the North 

east and Southwest regions where 

troubled real-estate assets as a per 

cent of real-estate loans and OREO 

led the nation at 5.31 and 6.67, re 

spectively. FDIC Quarterly Banking Profile, 

ThirdQuarter, 1993. 

Capital Ratios Seen Not to 

Deter Bank Lending 

Banks have continued to improve 

their capital ratios even though in re 

cent years most of them have met 

minimum capital standards, accord 

ing to data from a sample of 720 large 

banks (assets greater than $300 mil 

lion). From the fourth quarter of 

1990 to the fourth quarter of 1992, 

undercapitalized banks on average in 

creased their capital ratios more than 

other banks; however, even the ade 

quately capitalized banks as a group 

experienced a very large improve 

ment in their capital positions. 

The study shows the extent that 

banks have adjusted to capital stan 

dards both by increasing capital, and 

by reducing risk-based assets. Also 

indicated is that the higher-risk as 

sets were affected more by the cap 

ital constraints than the lower-risk 

assets. 

The study concludes that a large 

portion of the banking industry is 

well-capitalized, and thus while capi 

tal constraints may have caused some 

of the slow loan growth in recent 

years, banks' capital positions should 

not themselves now be a major deter 

rent to lending. Should other supply 

and demand factors be present for a 

turnaround in bank credit, banks have 

the capital to respond. Weekly Letter, 

Federal Rfserve Bank of San Francisco, 9/22/93. 

Bank Failures and 

"Problem Banks" 

As of mid-October 1993, a total of 

38 BIF-insured banks, and one 

SAIF-insured bank, had failed in 

the year. For the full year 1992, 

there were 120 insured bank fail 

ures. Seventeen of the failures this 

year were in California and another 

ten in Texas, these states together 

accounting for over 40 percent of the 

failed-bank assets. 

The number and assets of com 

mercial banks on the FDIC's "Prob 

lem List" continued to decline in 

the second quarter. At midyear, 

there were 580 institutions on the 

List, with assets of $325.9 billion, a 

reduction of 91 banks and $50.5 bil 

lion in assets in the quarter. 

The number of "problem" sav 

ings banks continued to decrease 

from the record level of a year ago. 

At mid-1993, there were 60 of these 

institutions, whose $37.1 billion in 

assets represented 18 percent of the 

industry's assets, down from 88 

banks and almost one-third of the 

industry's assets a year earlier. The 

industry's performance has benefit

ted from the FDIC's resolution of 

the most troubled institutions, the 

favorable interest-rate environ 

ment, and stabilizing real-estate 

markets in the Northeast. FDIC Quar 

terly Banking Profile, Second Quarter, 1993; and 

FDIC Public Information Unit. 

Survey Documents Bank 

Fee Increases 

Based on its 1993 survey, the 

Consumer Federation of America 

(CFA) said that over the last three 

years bank fee increases in some cases 

have been four times the seven per 

cent rise in the Consumer Price 

57 
FDIC Banking Review 

Index. Among the study's findings 

were: 

a) The average annual cost of a 

non-interest-bearing checking ac 

count increased 18,5 percent since 

1990. 

b) The net average annual cost of 

maintaining an interest-bearing 

checking account with a balance of 

$600 rose 41 percent since 1990. 

c) Fifty-nine percent of banks 

offer a no-frills, fee-based alternative 

to regular checking. These accounts 

generally charge a monthly fee re 

gardless of the balance and limit the 

number of checks included in that 

fee. The average annual cost to con 

sumers of a no-frills account is 

$136.30, a cost out of reach for many 

lower-income and elderly consumers. 

d) The average annual net cost of 

a savings account with a balance of 

$200 is $22.92 in 1993, an increase of 

143 percent since 1990, 

The study was based on data from 

300 banks in 22 states. Overall, the 

highest-cost states for consumers to 

bank were Florida, Massachusetts, 

New York, California, and the District 

of Columbia, and the lowest-cost 

were Washington State, Virginia, Or 

egon, Vermont and North Carolina. 

The proliferation of bank fees has 

obscured the costs of financial-ser 

vices products and has caused massive 

consumer confusion, the CFA said. 

Among its recommendations was that 

the Congress investigate the feasibil 

ity of requiring standardized pricing 

of deposit accounts to provide the 

consumers with the information they 

need to shop in the marketplace. The 

1993 PIRGICFA National Bank Fee Survey, U.S. 

Public Interest Research Group and Consumer Fed 

eration of America, June 1993; Press Statement, 

618193. 

Recent Articles and Studies 

Lessonsfrom New England 

Bank Failures 

While New England experienced 

only nine bank failures from the end 

of World War II through 1988, there 

were 92 failures of BIF-insured banks 

in the region in 1989 through 1992. 

Many of these banks were newly char 

tered in the 1984-89 period and were 

still relatively small; however, other 

failures involved institutions of great 

importance to the region. This study 

by Richard E. Randall investigates 

the causes of these bank failures, and 

discusses the various statistical and 

other indicators which from quarter

to-quarter reflected the growing prob 

lems, and the responses of bank 

managements and the bank supervi 

sors to the emerging developments. 

Of the 62 banks in existence before 

1984 that failed from 1989 to 1992, 

commercial real-estate loans were the 

dominant factor in 58 failures, they 

were a contributor to the problems in 

two failures, and were a non-critical 

factor in only two cases. Commercial 

real-estate loans exceeded 30 percent 

of assets in 47 of the banks, and were 

over 50 percent in eight banks. Prior 

to 1984, commercial real-estate loans 

seldom rose above 20 percent of as 

sets. The high concentrations of 

commercial real-estate loans led to ei 

ther failure or poor supervisory ratings 

in almost all cases. The exceptions 

involved mostly banks that followed 

policies of lending on existing com 

mercial structures rather than con 

struction. The real-estate loan 

problems in the region during this pe 

riod appear to have been based almost 

entirely on construction and develop 

ment lending and the resulting dam 

age to the economics of existing 

commercial properties. Banks that 

survived the period, though with large 

portfolios of commercial real-estate 

loans, in most cases did not have large 

concentrations of construction and 

development loans. 

When nonperforming loans began 

to exceed normal levels, most banks 

had already ceased making commer 

cial real-estate loans and commercial 

and industrial loans, or did so 

promptly upon the onset of problems. 

The large majority of banks did not 

continue to expand loans beyond a 

quarter or two after credit problems 

began to emerge. The exceptions 

were mostly small, new banks. Also, 

it appears that most decisions to dis 

continue lending were initiated by 

bank managements rather than the 

supervisory authorities. Finally, the 

banks did not try to "grow out" of 

their lending problems, as was the 

case with some savings and loan insti 

tutions during the mid-1980s. 

All 39 savings banks in this group 

failed as a result of heavy involvement 

in commercial real-estate lending, 

and like commercial banks, the sav 

ings banks showed rapid growth in 

those loans, resulting in high concen 

trations. The institutions generally 

reacted conservatively to the emerg 

ing credit problems as did the com 

mercial banks. 

Supervisory ratings show that 

banks were not downgraded based on 

their large concentrations of commer 

cial real-estate loans. Supervisory 

reaction to the developing credit 

problems began at the time or shortly 

after when nonperforming loans 

reached one percent of assets, which 

is a relatively low threshold that is 

used in most cases in this study. 

Once the level of nonperforming realestate assets exceeded one percent, it 

moved rapidly higher in most cases. 

In 16 of the 23 mature commercial 

banks, nonperforming real-estate as 

sets (commercial and industrial loans 

in two banks) reached three percent 

of assets within two quarters, and they 

did so in all but one of the remaining 

banks within three more quarters. 

Such assets reached six percent of 

total assets in 11 banks within one and 

one-half years. The evidence indi 

cates that a "gradual" recognition oc 

curred on the part of the supervisors 

of the seriousness of the problems. 

That the recognition did not come 

sooner is attributed by the writer in 

part to the fact that examinations of 

some banks focused more on policies 

than on detailed review of credit qual 

ity and lending terms. Apparently 

due in part to infrequent examina 

tions, there were two- or three-step 

drops in supervisory ratings in many 

cases. 

It was found that new banks often 

received less-frequent examinations 

than established banks, though a 

58 
Receni Developments 

tenet of bank supervision is that new 

banks should receive more-frequent 

examinations. Real-estate lending 

was a major, if not dominant, factor in 

19 of 25 failures of new banks (23 

commercial banks and two savings 

banks, whose charter dates ranged 

from 1984 to 1989). Most new banks 

reacted promptly to reduce risk from 

the emerging credit problems; how 

ever, a number of new banks contin 

ued to increase the combination of 

commercial real-estate and commer 

cial and industrial lending for more 

than one quarter after total nonper

forming assets exceeded and re 

mained above three percent of total 

assets. Over half of the 21 new banks 

for which supervisory ratings were 

available stopped expanding their 

troubled loan categories while they 

had supervisory ratings in the three 

top categories, suggesting that most of 

those banks that curtailed their lend 

ing in timely fashion did so on their 

own initiative. 

New England banks1 concentra 

tions in commercial real-estate lend 

ing do not mean that all the losses 

resulted from providing too much 

credit to any particular sector. Insti 

tutions often lowered underwriting 

standards and failed to exercise pru 

dent loan administration. The ag 

gressive actions of converted savings 

banks may have contributed signifi 

cantly to a liberalizing spiral of easier 

terms on construction loans. num 

ber of banks were reported to have 

financed 100 percent of costs and ad 

vanced even more to cover interest 

payments. A significant increase in 

fraud occurred during this period, 

caused for the most part by outsiders, 

sometimes with an officer or em 

ployee involved. New England Economic 

Review, Federal Reserve Bank ofBoston, May/June 

!993,pp, 13-38. 

IMF Discusses Risks of 

Derivatives 

recent report of the International 

Monetary Fund on systemic issues in 

international finance examines the 

growing involvement of international 

banks in derivative finance, the po 

tential risks from the rapid expansion 

of the over-the-counter (O-T-C) de 

rivative markets, and supervisory and 

regulatory approaches to the manage 

ment of these risks. While calling at 

tention to the systemic risk issues, the 

report does not make specific recom 

mendations. 

The derivative contracts market 

expanded eightfold in the five years 

from 1987 through 1991, from $1 tril 

lion to about $8 trillion. The fastest 

growth has occurred in O-T-G con 

tracts. The IMF said that "experi 

ence suggests that rapid expansion of, 

and concentration in, a particular 

banking activity often signals both a 

weakening of internal controls and an 

underassessment of credit risk." 

Although participants in the deriv 

atives securities markets are exposed 

to the same type of risks credit, 

market, liquidity, and legal risks as 

in other markets, the speed of market 

expansion and complexity of instru 

ments may have weakened risk man 

agement. Managements may not 

have a full understanding of some of 

the recent products, the report said. 

Also, the connections between firms 

in complicated derivative transactions 

can make counterparty risk extremely 

difficult to evaluate. 

The tendency for derivatives to 

create arbitrage opportunities and 

strengthen the linkages between mar 

kets has increased the possibility that 

disruptions or increased uncertainties 

in these markets may affect other de 

rivative markets and the cash markets 

more readily than in the past. Exam 

ples of where the potential for such 

problems has been evidenced are the 

global stock-market collapse of 1987, 

the bankruptcy of Drexel Burnham 

Lambert in 1990, and the European 

currency crisis in 1992. Among the 

issues that have caused concern in the 

financial community are the central 

banks1 ability to contain systemic 

difficulties that might involve a wide 

range of financial and nonfinancial 

firms, concentration of risk in the 

O-T-G market in a few major partici 

pants, systematic underpricing of that 

risk, and expansion of the financial 

safety net beyond banks to include 

nonbank financial intermediaries. 

Two public-policy approaches for 

limiting the potential for systemic risk 

that are discussed in the study are 

capital-adequacy requirements and 

prudential supervision for strength 

ening individual financial institu 

tions, and development of netting 

arrangements for derivative contracts 

to improve the payments and settle 

ment systems. International Capital Mar 

kets, Pt. II, Systemic Issues in International Finance, 

International Monetary Fund, 106 pp., August 

1993;AB,9/27/93,p.24. 

"Parallel'Banking" System 

Should Not Be Regulated 

Like Banking 

This article by Martin E. Lowy 

responds to a proposal (see the 

Spring/Summer 1993 issue of the 

Review) for a financial industry licens 

ing system, which would require all 

"parallel-banking system" firms to be 

licensed and to comply with the same 

major regulations as banking firms in 

respect to safety and soundness. 

The requirements as proposed would 

apply to any such entity that directly 

accepts funds from the public for in 

vestment, makes loans to the public 

or buys loans or securities using funds 

other than its own equity capital and 

retained earnings, or sells loans or 

third-party securities to financial in 

stitutions or investors. 

Lowy is in agreement that irres 

pective of the kind of institution, 

those activities that are functionally 

similar should be regulated in the 

same way. Such activities would 

include, for example, pools of capital 

that are sold to the public the same 

way {under the Investment Company 

Act) by different institutions, and 

other selling activities. Parallelsystem firms should be subject to reg 

ulations as are banks in respect to 

disclosures by lenders, duties of fidu 

ciaries, and the community obliga 

tions of lenders. However, banks 

differ basically from parallel-system 

firms in that they offer federally in 

sured deposits, and in the extent of 

59 
FDIC Banking Review 

their safety representations before the 

public. Thus, banks are subject to 

capital requirements and prudential 

restraints that should not be imposed 

on the parallel system. 

In the earlier proposal, concerns 

were expressed about the parallelbanking system causing potential 

problems for the Federal Reserve in 

respect to handling financial-system 

crises, and conducting monetary pol 

icy. In contrast, Lowy sees in parallel 

banking a system in which risks are 

spread broadly that were formerly 

concentrated, and a safer system than 

banking. He notes that large 

amounts of the commercial paper is 

sued by finance companies are pur 

chased by money-market mutual 

funds, which are diversified, are 

funded through sales of equity shares, 

and are virtually fail-proof. The par 

allel system is in fact not unregulated. 

Several of the leading finance compa 

nies are supervised by the New York 

State Banking Department, the mu 

tual funds are overseen by the SEC, 

and banks that provide the back-up 

lines are regulated. 

The author believes that the paral 

lel-banking system involves less risk 

and can provide services at lower cost, 

not only because of regulatory advan 

tages but also due to functional spe 

cialization and to the broad spreading 

of risk. Thus, the banking system 

should be freed to perform more like 

the parallel system. Bank holding 

companies, which are really a part of 

the parallel banking system, should 

be able to engage in other businesses 

and not be subject to restrictions on 

their strength or actions that do not 

involve the banks. Banks should be 

permitted to act as agents in a variety 

of businesses, including securities 

sales, mutual funds, and all types of 

insurance. AB, 7/6/93, p. 4. 

Report on Savings and Loan 

Industry 

The National Commission on Fi 

nancial Institution Reform, Recovery 

and Enforcement reported to Con 

gress, as required by the Com 

prehensive Crime Control Act of 

1990, on problems in the savings and 

loan industry, and recommendations 

for enhancing the safety and sound 

ness of depository institutions. The 

report is devoted mostly to historical 

information on the savings and loan 

crisis, with separate papers on specific 

topics such as criminal misconduct 

and insider abuse, accounting prac 

tices, industry lobbying, and the roles 

of the Congress and of the Executive 

Branch. Federal deposit insurance, 

while not the cause of the problem, is 

viewed as "fundamental" and a "nec 

essary condition" for the savings and 

loan collapse. Mistakes and defi 

ciencies in the regulatory-supervisory 

area are given considerable attention. 

The report emphasizes the imperfec 

tion of government regulation and 

supervision as a mechanism for pro 

tecting the public against losses from 

failures of depository institutions 

under the present system. In this 

connection, it should be noted that 

the historical material and conclu 

sions are based on the period up 

through the enactment of FIRRE in 

1989. 

Among the report's numerous rec 

ommendations for changes are the fol 

lowing: 

a) Allow institutions to offer feder 

ally insured deposit accounts solely 

through separately capitalized, feder 

ally insured, money-market funds au 

thorized to invest only in short-term 

debt instruments for which there is an 

active national market. Because 

these "monetary service companies" 

would hold only highly liquid, mar 

ketable securities, their condition 

would be marked-to-market daily and 

their risk exposure calculated. 

MSCs would be subject to risk-based 

capital standards and insurance pre 

miums, as well as vigorous and effec 

tive regulation and supervision by the 

FDIC. MSCs could be affiliated 

with other financial entities includ 

ing, but not restricted to, banks. 

They could share personnel and facil 

ities, but could not lend to, or have 

other financial transactions with affil 

iates or parent organizations, except 

in the payment of dividends (which 

would be regulated by the FDIC). 

b) Eliminate thrifts as separately 

chartered and regulated entities by 

converting them into commercial 

banks, and permit them to specialize 

in home-lending services if they so 

choose. 

c) Make the FDIC the sole federal 

insurer of depository institutions and 

the sole federal charterer and regula 

tor of insured depositories. The 

FDIC should remain an independent 

agency, reporting to Congress. It 

should be required to consult regu 

larly with the Federal Reserve and 

make available to it, on a timely basis, 

all pertinent information concerning 

the condition of insured depository 

institutions. 

d) Make all federally insured de 

pository institutions subject to federal 

rules, regulations, and examinations, 

but permit innovation and flexibility 

consistent with safety and soundness. 

Origins and Causes of the S&L Debacle: A Blueprint 

for Reform, National Commission on Financial 

Institution Reform, Recovery and Enforcement, July 

1993. 

60