Alan Greenspan: Banking supervision
Remarks by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve
System, before the Independent Community Bankers of America, Las Vegas, Nevada (via
videoconference), 7 March 2001.
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It is a pleasure to be here for the ICBA's national convention. From the largest, most complex
institutions to smaller banks serving the needs of their local communities, our nation's banking system
has thrived amid intense competition and has adjusted to a rapidly changing financial and
technological environment. Clearly, changes in financial markets have prompted supervisors and
bankers to re-evaluate past assumptions in this period of economic slowing and to initiate adjustments
that ensure banking promptly adapts to conditions that are less certain and less robust than the
extraordinary performance of recent years. In this context, I would like to review the lessons of the
past year and some of the issues and opportunities now facing banking institutions and supervisors.
After a near decade of unprecedented prosperity, the banking industry has come to recognize, not for
the first time, the embedded costs of lax credit standards and the overly optimistic assumptions about
borrower prospects that seem the inevitable consequence of ever-lower perceived risk premiums.
Today's problems generally relate to syndicated credits, especially those to leveraged borrowers. As
problems materialized, earnings fell significantly for some of the larger banks, which in turn caused
aggregate commercial bank industry earnings to fall slightly during 2000, thus bringing to an end the
industry's string of ten consecutive years of higher earnings.
Nevertheless, though the effects of these excesses are likely to continue for much of this year in the
form of moderately deteriorating asset quality and earnings at some of the larger banks, these
problems, one hopes, will prove modest both by historical standards and relative to the resources of
these institutions. Fortunately, we move into a period of uncertain times with the level of the industry's
overall profitability well above the average of recent decades. Moreover, the source of banking
revenues is better diversified than in the past, and most institutions hold strong capital and reserve
positions.
Not surprisingly, in response to past laxity, a weakening economy, and general economic uncertainty,
banks have tightened their lending terms and conditions. On commercial and industrial loans, our
Senior Loan Officer Opinion Survey indicates that tightening started in late 1999 and has persisted
through early 2001. The survey also indicated continued firming of the terms and conditions on
corporate loans by nearly 60 percent of domestic respondents, up from 45 percent in November. In
addition, more than 40 percent of respondents adopted more-restrictive terms on commercial real
estate loans, compared with 26 percent in November. Yield spreads on corporate loans, consistent
with risk premiums observed in the corporate bond market, have also widened. Adjustments in
standards and pricing are clearly a necessary and important part of the transition that banks must
make in moving from overly optimistic assumptions to more-realistic assessments of borrower
prospects.
As I have said previously, however, lenders and their supervisors, should be mindful that in their zeal
to make up for past excesses they do not overcompensate and inhibit or cut off the flow of credit to
borrowers with credible prospects. There is doubtless an unfortunate tendency among some, I hesitate
to say most, bankers to lend aggressively at the peak of a cycle and that is when the vast majority of
bad loans are made. A more disciplined, less pro-cyclical, long-term approach to lending that provides
higher average risk-adjusted returns to shareholders is obviously in the self-interest of banks.
It is interesting to note that the length of the current expansion, coupled with the absence of problem
commercial loans until recently, has led to some depreciation in both bankers' and supervisors' skill in
handling weakened or troubled credits. Such problems either are a faded memory or are outside the
experience of some lenders and examiners, despite the serious credit work-out problems of the late
1980s and early 1990s. As a consequence, institutions have had to brushup and re-institutionalize
their policies and practices for managing weakened and problem credits, and supervisors have had to
similarly bolster their training programs.
Recent problems have also helped vividly illustrate the longstanding virtues of sound lending
practices. For example, losses related to leveraged finance loans have reminded institutions that these
credits present unique challenges for an institution's risk-management systems and that proper
safeguards are necessary to conduct this business prudently and profitably. Leveraged borrowers, by
virtue of their high interest costs and dependence on third-party funding, have a diminished ability to
adjust to unexpected economic events and changes in business conditions. As a consequence,
leveraged credits require more-intensive tracking and monitoring than typical commercial credits to
ensure that their unique risk characteristics are adequately understood and controlled by the banking
organization. Institutions with sound practices translate the results of their monitoring into appropriate
internal ratings, classifications, and loss recognition to develop a timely and accurate picture of their
institution's credit quality and risk exposure.
Though much attention has been focused on problems in corporate loans, other segments have
remained fairly resilient. For example, commercial real estate loans are experiencing below-average
delinquencies and net charge-offs, as are residential mortgage loans. Furthermore, credit card net
charge-offs, which had escalated in recent years, have fallen to more moderate levels.
Still, prudent bankers will need to weigh the potential for less-agreeable credit conditions. In recent
years, buoyant economic conditions raised expectations for continued growth in income and
employment for consumers, which in turn have led to growth in household debt that has outstripped
gains in disposable personal income over the past five years. That growth in debt has pushed
consumer debt service burdens to levels close to the peak experienced in the late 1980s.
Neither borrowers nor lenders would enter into these obligations were they not optimistic about the
prospects for repayment. Not surprisingly, lenders have recently tempered their outlook, tightening
their standards somewhat for credit cards and installment loans. Concurrently, demand by borrowers
has weakened moderately. If loans have been extended assuming little or no possibility for
less-thanoptimal conditions, then problems are likely to emerge. Indeed, loans made using credit-scoring
models that are estimated only on data from the last five or so years may be too optimistic for more
normal conditions.
History provides excellent lessons for banking institutions with regard to appropriate pricing,
underwriting, and diversification. One of the most memorable, of course, was the real estate crisis of
the late 1980s and early 1990s. However, it is clear that such memories and their lessons can dim
over time. The exceptional demand for office and other commercial real estate in recent years has led
to a rebound in the volumes of loans secured by these properties. This time, however, as demand has
grown, larger organizations have managed to keep their holdings modest relative to their asset bases
either through securitizations or sales or by avoiding originations altogether. In contrast, many smaller
commercial banks have raised their commercial real estate concentrations relative to assets and
capital. Though underwriting practices appear to be much healthier today than they were in the 1980s
and standards have tightened somewhat recently, supervisors are paying particular attention to
community banks with concentrations that make them materially vulnerable to a downturn in this
market.
Although asset quality problems at a few of the largest banks may have received the most headlines,
a more lingering and widespread source of concern has been shrinking net interest margins. As
liability costs rose rapidly last year, nearly all of the largest bank holding companies experienced
margin declines, with about one-fourth experiencing a narrowing of 25 basis points or more since a
year ago. However, the aggregate net interest margin of community banks was essentially unchanged
last year. The more-favorable margin trends at community banks are probably linked to their
proportionally higher funding of assets with core deposits, which are less sensitive to rising rates.
Moreover, in 2000 the average rate paid on both large and small time deposits by small banks
declined relative to that paid by larger banks.
Despite pressures on funding, community banks have been relatively successful at maintaining their
core deposit bases. For example, a decade ago banks with less than $50 million in assets funded
around 80 percent of their assets with core deposits. Over the course of the past decade, that figure
declined 7 percentage points, but core deposits remain a fairly high, 73 percent of assets. For banks
with more than $10 billion in assets, core deposit holdings are only 39 percent.
Community banks have experienced only moderate diminishment in the share of core deposits funding
assets, but when that trend is coupled with rapid loan growth, pressures on bank liquidity appear to
have intensified. Community banks have funded the gap between loan and deposit growth largely by
liquidating investments. For example, from 1990 to the end of last year, smaller community banks
increased the share of loans on their balance sheet 8 percentage points, to 59 percent. Over the same
period, liquid funds and investments fell 8 percentage points, to 38 percent of assets. The combined
deposit and loan trends have pushed liquidity benchmark ratios, such as loans to deposits, to historic
peaks. However, there are some signs of relief for bank liquidity. For one, the demand for loans by
businesses and consumers appears to be moderating, and there are some early indications that
consumers are returning to bank retail deposits in the wake of disappointing stock and mutual fund
results.
Still, many of these liquidity pressures are likely to remain in one form or another, and banks will
almost certainly continue to explore nondeposit liabilities to fund asset expansion. While this is not
new to community banks, the growing volume, variety, and complexity of non-deposit funds creates
new issues. To meet this challenge, community banks must strive to fully comprehend the implication
of relying on these types of funds from both liquidity and earnings perspectives.
It is, of course, perfectly appropriate for institutions to consider alternative funding strategies to meet
customer demand. On the one hand, choosing to meet loan growth through wholesale funding rather
than attempting to attract new money market accounts, for example, may avoid a costly rate hike on
existing deposits. On the other hand, institutions should consider the costs of choosing wholesale
funds in lieu of building the institution's retail funding base. Significantly, the accumulated effect of
these decisions on an institution's risk and liquidity profile may not be noticed until difficult times place
pressure on the institution's ongoing funding. Management should keep in mind that the value of the
federal subsidy provided by lower-cost insured deposits is rarely appreciated until periods of crisis,
when a stable funding base cannot be maintained at any price.
Management should ensure that complex funding products are well understood, especially those with
embedded options that cause cash flows to change dramatically depending on market conditions. The
funding products should also be consistent with the portfolio objectives of the bank and the
sophistication of the bank's risk-management system. In addition, management should seek to identify
liquidity pressures and other risks through stress tests so that appropriate contingency funding and
hedging programs can be formulated.
It is important in this market to place the liquidity and core deposit erosion at both small and large
banks, as well as the resultant increased reliance on managed liabilities, in a proper historical context.
An unpleasant fact is that the wider range of choices for near-deposit substitutes, and broader
understanding by consumers of what those choices are, may have decreased, perhaps permanently,
the share of core deposits funding assets. This change may be as significant in the current banking
landscape as the tax on state bank notes was in the nineteenth century. To be sure, the imposition of
the tax was sudden, while the erosion of the share of funding from core deposits has been, and
presumably will continue to be, gradual. But just as state banks responded to the tax by innovating
deposit banking to flourish once again, community banks will, I am sure, adjust to the changing
realities of the deposit market.
Moreover, it is also important to recognize that the reduction in portfolio liquidity is more a product of
good business--high loan demand--than of the relatively slow growth in core deposits. Some liquidity
pressures will be alleviated as demand for loans declines. Though core deposits may be more difficult
to attract, they have in fact continued to grow, just not as rapidly as the loan portfolio. In fact, bank
credit over the past decade has grown faster at community banks than at larger ones, and so have
their deposits, both insured and uninsured.
But both the changes in financial markets and your success in credit markets suggest another
important area of risk management that requires increasing attention from community bankers:
maintaining enough capital and reserves so that your organization can absorb the losses that
inevitably occur as part of risk-taking in a strong economy. As you know, supervisors are proposing to
update the current Basel minimum requirements with a flexible system that is more finely calibrated to
a bank's underlying risk-taking. However, such an approach does not come without cost, either to
banks or their supervisors.
Recognizing that much of the new Basel Accord is tailored to the greater complexity and diversity and
the substantial risk-management infrastructure of the largest internationally active organizations,
supervisors issued an advance notice of proposed rulemaking on the potential use of simpler
approaches. That notice was predicated on the assumption that community banks might prefer
something even less complicated than the current standard. The responses we received are a lesson
in the importance of seeking comment on proposals that are largely guided by general impressions
and conventional wisdom. The responses to date indicate that community banks in general do not
believe that the current accord is burdensome, mainly because the costs of adapting systems and
reporting for such an approach have already been incurred. Indeed, some commenters indicated that
a change to an even simpler system would in itself be more burdensome than sticking with the current
regime.
The notice also asked whether the industry would be in favor of a blunt, stand-alone leverage ratio
with much less complexity and reporting. The catch to that proposal was that in exchange for less risk
reporting, supervisors would set the minimum ratio higher than is required by the current leverage
standard, which is used in tandem with the current risk-based system. Many of the responses
indicated that was not a favorable tradeoff, even though most community banks have exceptionally
strong leverage ratios. I should emphasize that we are still analyzing your many excellent comments
to determine what kind of response we should give.
In closing, then, the need for banking organizations to be flexible and adapt to the changes around
them has continued to intensify. As the extraordinary economic performance of recent years has
moderated, weaknesses that were once hidden have surfaced and have separated strong managers
of risk from weaker ones. Those that use their recent difficulties as a catalyst for improving their
riskmanagement practices are likely to flourish. In the coming years, institutions both large and small that
focus on risk-management fundamentals can expect to both support a growing economy and provide
strong returns to shareholders.