taking a stand on banking

According to Lowell Bryan, author of Bankrupt: Restoring the Health and Profitability Of Our Banking System, most institutional investment, a total of one billion in deposits and other b

The author has chosen to use a question-answer format in order to make the often complex subject matter, easier and more enjoyable to read Q and A is not a dialogue between real people the author has provided the dialogue for both Q, standing for Quaero, which is Latin means "I search for" and A, Auctor, which in Latin means

A: My initial approach is the same in dealing with any public policy issue Human nature

must be taken into account

First, people are going to do what they want to do They will find a way around the best laid government obstacles

Second, people act in their own self-interest and know better than an impersonal

government where those interest lie and how to attain them

Third, a free market, based on the first two premises, functions more efficiently than a bureaucracy

Q: I think you have just advocated "more of the same" -laissez faire -what might be

viewed by some as a prescription for disaster The current weakness in the economy has been traced to the weakness in the banking system

A: And the weakness in the banking system may be traced to regulations which distort

the market and wreak economic havoc

Q: I think the real question is whether regulators can protect taxpayers and promote

economic growth at the same time Are they mutually exclusive goals? Will easy credit hurt the banking industry?

A: According to congressman Charles Schumer of New York, the banking system is

shell-shocked from too much lending, too many new ventures undertaken in the eighties Now bankers are cautious and investing in U.S treasuries for safety Unfortunately government securities are non-productive liquid type investments that will not provide the shot in the arm that the economy needs at the end of 1991

Q: Why don't we start our discussion at the beginning with the earliest link between

government and banking in this country? Didn't we have a central bank early in our history?

Q: What happened?

A: There was the time-honored heated debate involving states rights versus federal rights

and as a result when the charter came up for renewal at the end of twenty years it was allowed to elapse Congress tried again, forming the second Bank of the United States in

1816

Q: And obviously that didn't last

A: It was virtually destroyed with the election of its foe, Andrew Jackson, in 1832 The

bank had become extremely wealthy and Jackson feared the power its officers could wield in influencing the government He order his Secretary of the Treasury to withdraw all government funds and instead deposited the government's money in various state banks, referred to as "pet banks" When the charter of the second Bank of the United States expired in 1836 it simply ceased to exist

Q: So when did today's federally chartered banks come into existence?

A: Congress passed the National Bank Act in 1863 to help finance the Civil War This

was the beginning of our dual banking system with some banks chartered and protected and regulated by the federal government and others by the state

Q: You know, the Japanese established the Ministry of Finance, their version of our

Federal Reserve system, in 1882

A: That was long before we established our own Federal Reserve System in 1913

Actually the modern structure of our banking system began in 1927 with the passage of the McFadden Act

Q: I've never heard of the McFadden Act

A: It denied nationally chartered banks the right to operate branches within a state unless

the already existing state chartered banks were given equal rights The McFadden Act originally permitted national banks to exercise securities powers It wasn't until 1933 with the passage of the Glass-Steagall Act that banks and savings and loans were forbidden to underwrite securities

Q: This was New Deal legislation instituted under Franklin Roosevelt Right?

A: Right It was an attempt to insulate the various types of banks from competition by

commercial enterprises and also to protect consumers from having their deposits used by banks speculating in the stock market

Q: I guess the crash of 1929 was a fresh and scary memory in 1933

A: Absolutely 5,500 banks failed in the 1920s In just the three years 1926-1929, 125

banks failed in Florida alone, as a result of insider abuses and conscious conspiracies to defraud The officers of the Palm Beach National Bank should have been indicted in the summer of 1926 for embezzlement and criminal fraud, according to the bank's receiver, but instead an official political statement was issued claiming the bank failed because of the local economy and unforeseen disasters which hit agriculture and industry in South Florida

Q: A cover up!

A: The officers of a defunct state bank were indicted for making illegal loans by a grand

jury in Palm Beach County a few months later

Q: I bet that was small comfort to depositors who lost their savings

A: Now it is taxpayers rather than depositors who pay for the excesses and abuses of

management

Q: You mean because ultimately taxpayers stand behind the government-guaranteed

deposits?

A: Exactly Let me backtrack to 1913 to the establishment of the Federal Reserve Bank

which was supposed to ensure the soundness of the banking system

Q: The number of bank closures during the Great Depression bears testimony to the fact

that it didn't do its job

A: You should know by now that when one agency fails to do its job, the usual

government solution is to add another agency and so we got the Federal Depository Insurance Corporation (FDIC) and the Federal Savings and Loan Insurance Corporation (FSLIC)

But just like any safety-net, deposit insurance, introduced in the 1933 Glass-Steagall Act, has encouraged risk and poor management It has distorted the system

Q: What do you mean?

A: Originally the Federal Depository Insurance Corporation (FDIC) was supposed to stop

runs on banks, but instead it has effectively stopped depositors from keeping an eye on their savings, and bankers from being prudent

Q: Best selling author and former banker Paul Erdman, on March 5, 1987, told his

Commonwealth Club audience that

Every money center bank in the U.S gets over half its deposits from abroad the consensus of the Wall Street types is that it (i.e run on U.S banks) has a 25 percent chance of occurring

But no big deal, he said, even if runs occur the world's money has no better place to go!

A: FDIC insurance now covers any deposit up to $100,000 As long as a deposit remains

under that $100,000 level it is the responsibility of Uncle Sam to monitor bank judgment

Q: How many people do you know with $100,000 sitting in the bank?

A: You've got a point But it's worse than you think Currently an individual or group can

be insured beyond the $100,000 limit just by opening another account once the $100,000 insurance limit is reached in one bank A recent reform limited the number of insured accounts to two in any one bank

Q: Some reform! The customer could go across the street to open up accounts three and

four!

A: Well I know if the Bush administration were to have its way, large pension fund

deposits would no longer be insured on the pass-through theory

Q: What in the world is the pass-through theory?

A: The theory that says that entities like pension funds, should be considered as so many

individual deposits, each below the $100,000 ceiling deposits The fact that they are lumped together should be overlooked for insurance purposes

Q: Maybe it's time something was done towards gearing bank premiums to risk and

perhaps even trimming the guarantee from $100,000 to a modest sum more in keeping with the average man’s savings, since he is the one who gets tapped if a bailout is needed And how about prohibiting one person from having several insured accounts totaling over

$100,000?

A: Why not? Pay outs could be lessened by reducing the dollar amount of deposits

covered below $100,000 and limiting the pay outs to a per person liability rather than per account That was supposed to have been done in 1984 when the FDIC and the Federal Home Loan Bank Board supposedly banned new brokered accounts

Q: Brokered accounts? Is that what they call the really large deposits which are split into

$100,000 accounts split to take advantage of FDIC insurance limited to that amount?

A: You've got it!

Another idea is to balance the FDIC's income-outgo ratio by co-insurance

Q: You mean requiring the depositor to pick up at least some of the tab for insuring his

own particular account?

A: Absolutely In fact why not do away with the FDIC and go back to caveat emptor

Q: In other words, why not let individual depositors shop for their own deposit

insurance?

A: Opponents claim banks would be open to runs, something deposit insurance was

supposed to alleviate Besides, private insurers couldn't begin to assume a $4 trillion liability

Q: Then why not categorize banks? There could be "safe banks" where deposits are

invested in government and agency securities, and home mortgages These banks could

be covered by the FDIC -backed ultimately by taxpayers "Risky banks" would have more investment latitude but depositors would not be provided with insurance Of course they could obtain their own

A: Dream on! Insurance for depositors of a risky bank would be sky high But I see two

other problems:

First, most consumers would prefer the risky banks because of the higher possible returns Americans are optimists! According to Lowell Bryan, author of Bankrupt: Restoring the Health and Profitability Of Our Banking System, most institutional investment, a total of one billion in deposits and other borrowed funds, would leave the insured safe banks

Secondly, the investments that make safe banks safe, like Treasury bills and so forth, are

already backed by taxpayer guaranties, making FDIC protection redundant

Q: From what I read, Lowell Bryan would favor categorizing the banking business He

even refers to core banks, federally insured and in the business of taking deposits and

lending to small enterprises He envisions only ten to twenty of these banks formed via mergers of what are now the 120 largest bank holding companies who have two-thirds of the country's deposits

My facts differ from yours In a review of Mr Bryan's book [Business Week 8-5-9]) it

was said that:

Of the $2.6 trillion now in bank deposits, Bryan calculates, about $600 billion might leave core banks for higher yields offered elsewhere

More risky business would go to money-market investment banks and finance companies which would primarily make loans to real estate investors

A: What can I say? Co-insurance is something to play with though

Q: I like the idea of co-insurance too There are almost unlimited possibilities for funding

insurance by combining, in one way or another, resources of the government, the banking industry and of individual depositors

Q: Where does FDIC get its money now?

A: Banks pay premiums into the Bankers' Insurance Fund (BIF) These premiums

exceeded disbursements leaving as much as $18.3 billion in the fund as recently as 1987 But by the end of 1991 the insurance fund had dropped pretty near to zero because of the increased number of pay outs

Q: You mean pay-out caught up to premiums?

A: Exceeded premiums, because of the large number of bank failures

Q: So you're saying by 1992 the insurance fund will be insolvent?

A: Not so much insolvent, as illiquid

Q: What's the difference?

A: Insolvency is a permanent inability to meet obligations whereas illiquidity signifies a

temporary but rectifiable shortfall The BIF, which is part of the FDIC and because more people are familiar with the FDIC I will simply use that term for ease of discussion, still has a source of income and good long-term prospects of solvency It's just that its income

is spread out over a long time period and the need for disbursement is concentrated and immediate because of the unprecedented bank failures

Q: So what's the solution?

A: Adding capital to a reformed system

A: Yes, adding capital to a reformed system

Q: Oh, is that all?

A: Let's take it a step at a time As we said, we can give the FDIC an infusion of capital

by borrowing, either from the banking industry, the Federal Reserve Board (Fed) or taxpayers Which will it be?

Q: I have a sneaky feeling that this is one of those questions where no matter the answer;

it's going to come down on the taxpayers

A: Let's eliminate the Fed as a potential saviour because of the precedent any bailout of

the banking industry by that independent agency would set There are plenty of other agencies that would soon press the Fed to advance funds to them

Q: But I thought the Fed was expressly set up to insure the stability of the nation's

financial and banking system Having the Fed ride to the rescue seems to be a legitimate and practical solution

A: You're right that the Fed can, should, and has inserted funds into the system in

emergency situations to insure stability, but we're talking here about long term recapitalization of an insurance fund Let's examine the other alternatives

Congress has recently [fall of 1991] been working out the fine points on legislation that would have the Treasury loan seventy billion to recapitalize the FDIC

Q: The U.S Treasury? Just as I thought; that's in reality a taxpayer bailout just like the

Savings and loan bailout

A: Not "just like"

Q: Oh sure, the banks will pay back the loan out of premiums—maybe even larger

premiums due to higher assessments, but remember the savings and loans were supposed

to pay back taxpayers (the Treasury) out of the sale of foreclosed assets

A: That's different Those assets were mostly real estate Due to changes in the tax code

and the economy, real estate values have fallen and the cost to foreclose and manage them has gone through the roof

Q: Not to mention the regulations and restrictions which have hamstrung the liquidation

process

A: There's no doubt that the delays have been extremely expensive But you must admit

that the source of loan repayment by the banks is more easily identified than the source of the S & L loan repayment

Q: You mean the banking industry reimburses the Treasury via premiums charged to

member banks whereas thrifts are forced to depend on the proceeds from asset mainly real estate

sales -A: Exactly right Premiums receivable can be calculated, whereas the net income from

property sales is inscrutable

Q: But what is not known is the cost of an undetermined number of bank failures That

cost will ultimately determine the net premiums available to service any Treasury loan to the FDIC

A: That's why the solution is more than recapitalization Reforms are needed to reduce

the number of bank failures

Q: Reforms such as?

A: That is the debate that is going on Some experts favor measures to restrict the range

of bank activities, linking deposit insurance premiums with individual bank risk, raising the capital requirements of banks and more frequent examinations of bank records and management

Q: I suppose which activities and the degree of restriction would be left to fallible

legislators and regulators, many with little expertise in financial fields This does not sound like something you would favor

A: You're right Aside from my philosophical abhorrence, I see giant pitfalls and would

prefer that the marketplace determine the kind and degree of restrictions If regulators are too restrictive they could cause, rather than prevent, bank failures

Q: Don't forget the cost entailed in requiring more frequent examinations and higher

capital reserves

A: Bank managers will have greater incentive to act prudently once they have more

capital on the line and this, by itself, should reduce the probability of bank failures

Q: What about tapping the reserves of the banking industry?

A: That's on the agenda For instance, I can't figure out why foreign deposits are

by-passed when calculating the premiums banks must pay into the Bank Insurance Fund

Q: You mean foreign deposits aren't insured now?

A: They're insured if the bank fails but they are not counted when determining the size of

a bank's premium They get a free ride

Q: I would think that would make foreign funds a preferred source of capital for banks! A: You're right This is a regulatory induced bias

Q: I've got another idea In his 1991 book, The S&L Debacle, Professor Lawrence White

suggested,

All banks would be required to buy amounts of "preferred stock" in the FDIC equal to one percent of their domestic deposits, and they could carry this stock at par on their balance sheets

This way the FDIC would get an infusion of approximately $25 billion and banks would receive dividends on their investments Since they could carry the preferred stock on their balance sheets as an asset, the banks net worth for accounting purposes -assets minus liabilities would not go down

A: Excuse me Wouldn't that amount to double-counting? I can't see letting the FDIC

include the twenty-five billion banking contribution in its resources while also allowing the banks to carry the par value of the twenty-five billion preferred stock on its books

Q: OK How about if the preferred stock is publicly held and traded just between banks,

and the preferred stock is carried on bank balance sheets at current market values as reflected by that trading?

A: I don't think it is possible to strengthen the FDIC via banks funds, without weakening

the banks

Q: If I'm right, banks place their capital reserves with the Federal Reserve Bank which

gets away without paying any interest on those reserves Why not make the Fed pay interest?

A: Sounds good on the surface, but remember the Fed pays any excess funds into the

Treasury, so any interest paid by it would ultimately reduce the Treasury's income and just be one more hit on the taxpayer

Another suggestion is to lower the legal lending limit of federally insured institutions

Q: What are the lending limits now?

A: Most banks can lend somewhere between ten percent and twenty percent of their

equity to a single borrower

Q: Based on the safety in diversity maxim, I suppose

A: Correct If banks were held to lower limits—say two percent to five percent, they

would be forced to diversify even more and their lending capacity would be spread more thinly over a broader spectrum

Q: Wouldn't that hurt the large borrowers?

A: I'm surprised at your concern Large borrowers generally have many sources of funds

Small and medium size borrowers have fewer alternatives and this policy would actually free up funds for them

Q: So you would favor this regulation?

A: You're trying to catch me in the inconsistency of favoring regulation Let me put it

this way If there has to be regulation, then limiting individual bank's exposure to large speculators and opening up capital sources for a greater variety of more modest endeavors, is one of the better regulations

Q: I've heard it said that if insured banks had the same loss rates that they enjoyed prior

to 1980 that they would have suffered only nine billion in bank loan losses in 1990 instead of $29 billion actually recorded Is this true?

A: Perhaps there is a clue in the fact that only one Canadian bank failed during the 1920s

and 30s Bert Ely, who has written a book for the Cato Institute which details the banking collapse in America in the early 1930s, attributes the relatively smooth sailing that took place over the same time period in Canada to the fact that ten banks operated four thousand branches throughout Canada This gave Canada's banks a broad geographical dispersion for their banking risks

The independent bank, far from being the strength of small town America was its greatest weakness according to Mr Ely He believes the banking collapse in America in the early 1930s was caused, at least in part, by the restrictions on branch-banking which kept U.S banks unnaturally small

In 1930 there were 23,700 banks and only three percent of them had any branches at all

In the early thirties the typical bank failure could be traced to fraud or a local economic disaster

Q: Interesting

A: Of the 4,800 bank failures during the Great Depression era, most banks were too small

to carry on investment-banking activities and therefore there was really no justification,

Mr Ely points out, for enactment of the 1933 Glass-Steagall Act

Q: That's the law mandating separation of commercial from investment banking Are

other countries having banking problems or is this unique to the United States in the 1990s?

A: Bank regulators from around the world met in Amsterdam at the end of 1986 and

expressed their concern about the dangerous banking practices which they feared might have the potential to touch off a global banking crisis

According to L William Seidman, Chairman of the Federal Depository Insurance Corporation (FDIC), bank failures increased from 49 in 1983 to 138 in 1986; 80 percent taken over by healthy banks and 20 percent liquidated A report issued by the House Government Operations Committee in Washington DC, claimed of all the banks that failed between January 1980 and June 1983, 61 percent were involved in actual or probable criminal conduct

Q: Probable criminal conduct? That means a prosecution and sometimes a trial must take

place in order to determine if the conduct was criminal I'd also like to point out that 1,700 new banks were founded between 1981 and 1985

A: Many experts believe the nation’s banking system is resting on quicksand There is a

scary scenario that must be considered: the collapse of one large bank could lead to the failure of many more interconnected banks; business credit would then be constricted and surviving banks would be unable to purchase the bonds that major corporations depend

on to finance their operations and expansions It is possible that as desperate bankers try

to stave off collapse, loans would be called, causing defaults and bankruptcies throughout the economy

Q: Not a pretty scene to contemplate Listening to the dangers, one wonders how our

banking system has survived as long as it has

A: The fact that it has survived should tell you something about the scare mongers

Between 1865 and 1933, before the government insured deposits, depositor-losses averaged only 0.78% of the total deposits in all commercial banks

Q: Before the FDIC? I thought there were all kinds of bank runs

A: In a study published by MIT Press in 1986, titled Perspectives on Safe and Sound

Banking: Past, Present and Future, it was argued that costs imposed by bank failures and associated runs, were no greater than costs imposed by the failure of non-banking firms Runs were examples of depositor discipline that shut down poorly managed and insolvent institutions

Q: You mean the market at work

A: I guess you might say that But even though these losses were small, they nevertheless

exceeded the losses of the FDIC between 1988 and 1989 According to the report, “FDIC losses were approximately 0.25 percent of total bank deposits at insured banks or roughly one-third of the depositor losses experienced during the crisis years prior to deposit insurance.”

Q: If insurance cut the loss rate by two-thirds, you don't think anybody is going to want

to do away with it do you? Besides, bank panics are contagious

A: The study showed that only two or three episodes before 1930 suggested any

contagion as “indicated by substantial increases in nationwide currency-deposit ratios and absolute declines in bank deposits These researchers argue that the U.S banking system was fundamentally sound prior to federal deposit insurance and was not prone to destabilizing banking panics.” That was said by Jonathan Neuberger, Economist for the Federal Reserve Board of San Francisco on April 21, 1991 He also said, “research suggests that banking markets are fundamentally stable and not prone to contagious runs."

Q: What did currency have to do with it?

A: In the early 1930s, frightened depositors irrationally converted their bank accounts

into currency U.S currency is still the most widely used medium of exchange Today there is more than $250 billion worth of currency in circulation and those who hold it don't have to worry about risk of default

Q: They do have to worry about theft or losing it Credit cards and checking accounts are

much more convenient and favored, I'm sure, by most people

A: In their 1963 study of monetary history, economists Milton Friedman and Anna

Schwartz claimed that the monetary contraction of the thirties intensified the economic depression They blamed the Fed for failing to pour reserves into the banking system

Q: I would imagine the lack of funds, led to the bank runs which in turn produced a

credit crunch which acted as an additional drag on the economy A domino effect—right?

A: That's one theory In 1987 the FDIC insured 14,822 institutions with over two trillion

in deposits, and for the first time since its founding, FDIC reserves of slightly more than eighteen billion were in danger of running out The Federal Savings & Loan Insurance Corporation (FSLIC) which then insured thirty-two hundred Savings and Loan companies, was technically bankrupt as 1987 began

Q: Experts tell us that reforming the deposit insurance system is necessary for the health

and long term profitability of the banking system But I want to know how this is going to

be done?

A: Interstate banking and branch reform would help Cost savings from mergers has been

estimated at ten billion in pre-tax savings Remember the industry earned only $24.5 billion before taxes in 1990—less than an eight percent return on equity overall

Consolidation and interstate branching would help banks raise the capital they need Over

a five year period, the capital created from these savings could support more than $600 billion in new lending

Q: This is the way I see it: When OPEC money came pouring into this country in the late

seventies it had to be recycled and the bankers decided that a lending spree to the Third World countries would do the trick At the end of 1982 the nine largest U.S banks had lent 146 percent of total capital, reserves, equity and subordinated debt, to Latin American borrowers Not surprisingly, by the end of 1986 the list of problem banks totaled 1,484 Since not all banks acted irresponsibly, it only makes sense to determine capital requirements and insurance premiums according to the actual risks assumed by individual banks

A: The catch is not all risks are known or knowable

Q: But if they could be identified you can see how capital requirements at the higher-risk

banks would encourage those banks to be more careful Right?

A: If is a tiny word but a powerful obstacle This is not a simple problem

Off-balance-sheet items are involved and then there's the interdependency of foreign banks, many unregulated, with U.S regulated ones To tell you the truth, I'd rather save a discussion of our interaction with foreign banks until a little later, if you don't mind

Q: OK I'll backtrack We talked about the FDIC—bank insurer Would the same

discussion apply essentially to the FSLIC—the insurer of the savings and loan industry?

A: Essentially Since its beginnings in 1933, the FSLIC had supported itself with

premiums from institutions it insured and with income from investments Even though it had the authority to borrow up to $750 million from the Treasury, it never needed to do

so before 1987

Q: That sounds like the taxpayers would be left holding the bag if the losses resulted in

the institution's collapse

A: It is this open-ended liability with no limits to future costs which needs to be

reconsidered

Q: Who had oversight? Any institution besides Congress?

A: The FSLIC was controlled by the Federal Home Loan Bank Board which admitted

that $6 million a day was going down the drain because of the sick institutions it was keeping alive in early 1987

Q: Why in the world was it keeping sick institutions alive?

A: The 99th Congress was unable to pass legislation which would have pumped fifteen

billion into the ailing FSLIC and would also have permitted regulators to sell failing institutions Opponents argued that additional legislation wasn't necessary since many state laws already allow such sales On top of that, the U.S League of Savings Institutions incorrectly estimated the FSLIC would have $17.42 billion to cover pay outs over a five year period

Q: But if I remember correctly, the money requested was in the neighborhood of $25

billion

A: Right Legislation to raise that amount over a five year period was put before the

100th Congress Under the Treasury’s plan the Federal Home Loan Banks would have sold debt, backed by zero-coupon bonds, for about fifteen billion over a five year period with an additional ten billion to come from income from other investments and special assessments on federally insured thrifts

What Congress actually passed in the summer of 1987 was considerably less ambitious The banking-reform bill provided a $10.8 billion industry-financed package for the ailing Federal Savings and Loan Insurance Corporation, banned the creation of any more

limited-service banks and prohibited banks from entering any securities businesses until March, 1988

Q: Why didn't they just combine the two insurers—FDIC with FSLIC?

A: Some people did suggest that merging the FSLIC with the FDIC would, back in 1987,

have provided nearly twenty-nine billion to handle bank and savings and loan failures over the next five years without dipping into the corpus of the FDIC fund Former head

of the FDIC, William Issac, was not one of them, nor was his successor, William Seidman Both men were against a merger

Q: How did bankers and savings and loan officers feel about a merger?

A: Of course there were a variety of individual opinions but in general the commercial

banks were afraid a merger might mean an increase in their deposit insurance premiums and would amount to the bankers' bailing out the thrifts The savings and loans were not exactly overjoyed, fearing a merger might mean their ultimate extinction, or at least stricter controls

Q: That's chutzpah! It's not as if they were doing such a great job regulating themselves

A: I read in the August 1983 copy of California Lawyer that loopholes were tightened so

it was harder for non-banking companies to acquire banks and run them as strictly consumer-banking organizations In December 1983, non-banks were brought under the jurisdiction of the SEC by attempts to broaden the definition of lending to include the purchase of commercial paper, and the definition of deposits to include NOW accounts

Q: I remember some people questioned the idea that purchasing certificates of deposit

should be equivalent to making a loan

A: In 1984, despite protests from the Florida Bankers Association, the Fed gave United

States Trust Co of New York, the go-ahead to convert a state-chartered trust company to

a nationally chartered consumer bank This was a first

Q: Why did the Florida group object?

A: They felt the Fed's action violated the section of the Bank Holding Company Act

which prohibits banks from owning non-banking entities They exaggerated a bit and suggested that a local car wash or local bordello could now own a bank

Q: I've never heard of the Bank Holding Company Act?

A: The Bank Holding Company Act of 1956 forbade holding companies owning more

than one bank from operating in various states without express approval from the states themselves In 1970 even one-bank holding companies were brought under the jurisdiction of the Federal Reserve Board These regulations were a response to the rapid

expansion of financial conglomerates, mostly based in New York Legislation was pushed by members of congress from states such as Texas and Illinois where state banks weren't even allowed to open branch offices intrastate

Q: I remember when Bank of America was the largest bank in the world

A: In 1970 the ten largest banks in the world in terms of assets, were American Now

none are

Q: What do you think about the merger of BankAmerica and Security Pacific, two of

California's largest banks, which took place in August 1991?

A: For one thing it shows the pressure banks are under to expand in order to cut costs and

counter the bad loans accumulated over the years Expansion is their ticket to competition with the larger foreign banks

Q: Does that mean BankAmerica is now the largest bank, at least in this country?

A: In terms of branches, 2,400 and ATMs, 4,000 you're right But even with the merger,

its assets are $190 billion versus almost $217 billion at New York based Citicorp But although Citicorp has more assets than BankAmerica, BankAmerica is ahead in profits and is controlling its expenses The BankAmerica-Security Pacific merger is supposed to save about $1 billion in annual operating costs over a five year period Besides, Bank of America has more equity capital than Citicorp

Q: And with its equity capital it can expand beyond the ten states in which it presently

operates

A: Not only can, BankAmerica's CEO, Richard Rosenberg intends to expand his

operation In fact earlier in 1991 he was foiled in his attempt to purchase the Bank of New England (acquired by Fleet/Norstar Financial Group) which was especially attractive to Mr Rosenberg who is himself a native of the Boston area

Q: Surprisingly it wasn't that long ago [1986] that Bank of America was itself almost

swallowed by First Interstate bank

A: Just to show how life is unpredictable, on August 16, 1991 Richard Rosenberg

addressed the San Francisco-based Commonwealth Club This was only a few days after his bank's merger with Security Pacific

Q: Isn't Security Pacific the bank that sold some of its consumer and commercial service

groups to Japan's Mitsui Bank in the summer of 1989?

A: You're right Mitsui reportedly paid Security Pacific $100 million for a five percent

share, valuing the financial services businesses at fifteen times operating earnings

Q: That's unbelievably high I suppose that's because banking analysts preferred regional

banks like Security Pacific to money-center banks like BankAmerica and Citicorp

A: Possibly, and perhaps with good reason Money-center banks were involved with bad

loans to LDCs—lesser developed countries—an issue that was newsworthy and damaging a few years ago In fact in the summer of 1989 federal regulators required a write down of some of those LDC loans which made the regional banks like Security Pacific, look good in comparison

Q: But that was then and this is now

A: That's astute! Mr Rosenberg talked about the overcapacity of the American banking

industry and predicted more mergers in the future between the larger banks He pointed

to his own just completed merger and to the Chemical Bank and Manufacturers Hanover merger which had taken place in July 1991 as examples

Q: Did he think mergers were a good sign?

A: Yes, in as much as he saw overcapacity, along with restrictive legislation, as

significant contributors to the competitive disadvantage American banks have been suffering in the global market

Q: If I recall, Richard Rosenberg took over the retail division at BankAmerica back in

1987?

A: That's right He had been the President of Seafirst in the state of Washington He had

turned down the BankAmerica job twice before

Q: He apparently has a reputation as a great marketer

A: Absolutely He encouraged customers to use services beyond checking and savings

accounts—safe deposit boxes, IRAs, CDs, credit cards—which all earn separate profits

Q: Many experts think Mr Rosenberg was primarily responsible for turning around

BankAmerica's fortunes

A: As you said, he is a great marketer He used gimmicks such as giving away three

years of free checking accounts to anyone who walked in the door of any Bank of

America branch on a certain day, or if a new checking account was opened before a certain date the customer received coupons worth up to $1,200 at American Airlines, Hertz, Hilton and Carnival Cruises

Q: Aggressive marketing of banking products may be the key to the future success of

banks

A: It's here today Already consumers use banks not only as a place to deposit their

money or for the convenience of checking accounts, but they purchase certificates of deposit, have payroll checks direct-deposited and can get cash through interbank ATM networks

Q: You forgot to mention loans Credit cards often make it possible to draw loans from a

variety of institutions across the country With a little work, consumers can find competitive rates

A: Not only that, competition has meant more convenience for consumers Many banks

now stay open forty-five hours a week instead of twenty-seven as was the norm just a couple years ago Some are even open Saturday and a few hours on Sunday and others offer twenty-four hour phone information

Q: These services must be costly to provide

A: The costs are passed on to consumers who don't seem to mind as long as volume

allows the banks to keep individual charges low

Q: The something for everybody principle I understand that BankAmerica serves over

five million households and has been earning over a billion dollars a year

A: That's right It is reportedly the most profitable bank in the nation In 1990 it

purchased banks in Oregon, Arizona and New Mexico and now owns the largest in bank

in California, Bank of America, and in Washington, Seafirst

Q: I heard that between 1987-1990 its consumer lending more than doubled from

nineteen billion to thirty-nine billion

A: I know; it's amazing Mr Rosenberg had the thirty-one bank districts in California

hold recognition dinners and sales rallies The morale was high to the extent that each branch office had its own colors and unique branch cheers

Q: Sounds like high school sports or Amway sales rallies

A: The bank instituted incentive pay and recruited many of their current top management

personnel from Wells Fargo bank They managed to pare problem loans from five billion

to three billion over only three years

Q: Is it true that most California banks pay less on consumer deposits than competitors

pay in other states?

A: I guess it is In 1990 BankAmerica paid consumers only 6.7 percent—the consumers

then paid the bank eighteen percent on credit cards and ten percent plus to borrow on the equity on their homes Meanwhile Citicorp in New York paid eight percent That saved

BankAmerica seven hundred million and accounted for half its pretax profits As we said

at the beginning, consumer banking can be very profitable

Q: Not to mention the loss carry-forwards the bank had from its years of enormous

losses

A: But these tax breaks, which are said to have added two hundred and forty million to

1990 net income, disappear in 1991 This, plus the recession may mean 1991 is a learner year

Q: I heard something about BankAmerica buying at least a dozen failed savings and

loans from the Resolution Trust Corporation [RTC is the government agency set up in

1989 to dispose of the assets foreclosed during the S & L fiasco of the late 1980s.]

A: That may be If you are worried about the possibility of a future monopoly, remember

the numerous new nonbank companies

Q: It's hard to determine what institution is and is not a bank now days

A: It's interesting to see how that came about Congress had defined a bank as an

institution that accepts demand deposits and makes commercial loans In a 1980 case, Gulf & Western Corporation substituted personal loans for commercial loans and viola, the first consumer bank was recognized

Q: Some people say we have too many banks for our population in this country anyway

Do you agree?

A: I'd like to see the market place take care of that possibility Mr Rosenberg pointed out

that American consumers are served by 12,600 commercial banks, 2,000 savings and loans and 16,000 credit unions For instance Canada has 65 commercial banks, Japan has less than 150 commercial banks for a population of about 120 million people and Europe, with a population close to 320 million has about 3,000 commercial, savings and mutual banking companies Our own commercial banks have been slowed while their competitors have been allowed to race around the course without any such handicap

Big Firms like General Electric, General Motors, Sears; none of them, or others like them that offer bank or bank-like products and services has to adhere to bank regulations or meet capital standards that banks must meet, or hold reserves at the Federal Reserve Bank, or most importantly, meet stringent Community Reinvestment Act requirements—this despite the fact that these competitors are extending credit in direct competition with the banks

Q: It's my understanding that bank charters have been readily granted in the USA and

until the late 1980s foreign banks were able to open branches anywhere in the country even though domestic banks were prohibited from doing the same thing in Japan Correct?

A: Japan doesn't allow foreign banks to develop money market instruments or manage

mutual or pension funds in its country The Japanese Ministry of Finance keeps interest rates low and gives Japanese banks their lower cost of capital David Mulford, Under Secretary of the Treasury for International Affairs, said in early 1990, “Basic deregulation, sweeping change or bold challenges to the way the existing system benefits traditional Japanese financial institutions are hard to find Full deregulation is what is needed… The failure by Japan to provide full access to its markets is particularly serious, given Japan's current financial and economic position in the world.”

Q: That doesn't seem fair

A: It gets worse American laws allow foreign competitors to engage in the most

profitable lines of banking business without carrying the same cost burdens of American banks On top of this, our own commercial banks end up paying premiums that insure the brokered deposits of investment banks that cater to generally the most sophisticated financial consumers

Q: In addition to the expenses and costly regulations imposed on domestic lenders,

foreign lenders have access to cheaper overseas funds

A: Exactly so These foreign entities can therefore offer better interest Is it any wonder

they cornered thirty percent of the loans made to American business in 1991?

There's no doubt American banking regulations benefit foreign competition Thanks to the International Banking Act of 1978, approximately fifteen large foreign banks were exempted from the provision in the 1933 Glass-Steagall Act which prevents American commercial banks from underwriting corporate debt or equity offerings in the United States

This unfair advantage has contributed to today’s situation where only one U.S bank, Citicorp, can be found in the ranks of the ten banks with the most assets in the world Last year a subsidiary of the Union Bank of Switzerland managed debt issues for Borg-Warner Acceptance Corporation, Transamerica Financial Corporation and Allied Signal—all in New York Many foreign banks have been on a spree, buying shares in American investment banking establishments

Q: That's right Not long ago Sumitomo Bank of Japan purchased a five hundred million

dollars share in Goldman Sachs, one of Wall Street’s more prestigious firms in order to break into investment banking in this country

A: To counter the ridiculous situation that allows foreigners to own banks in more than

one state while making it illegal for a domestic bank to do so, in 1987 twenty states adopted reciprocal privileges

Q: Reciprocal privileges? What do you mean?

A: Certain states allowed citizens of other states to own banks within its borders as long

as the privilege was reciprocated

Q: Alan Greenspan, Fed chairman, said in April, 1990, “There is reason to believe that

the opportunity for a bank to diversify the products or services it offers or to diversify geographically may in some cases raise its rate of return and lower its risk.”

A: Well you can see something is being done about geographical diversity

Q: When are we going to do something about product diversification?

A: Congress has been urged to pass legislation that would overhaul the Glass-Steagall

Act and permit banks to engage in underwriting of commercial paper, mortgage-backed securities, revenue bonds and mutual funds

I remember when now retired Senator William Proxmire, was chairman of the Senate Banking Committee, he wanted to dismantle all or part of the Glass-Steagall Act He saw

it as a legacy he wanted to leave the country

Q: Why not allow capital-rich companies to affiliate and add their capital base to

individual banks?

A: It's the same old territorial scenario Those that have a good thing going are never

anxious for competition

David Silver, President of the Investment Company Institute, in his article for the April

1987 edition of the Financial Planning News, expressed a fear that Congress might be getting ready to repeat what he referred to as the disastrous 1927 McFadden Act Mr Silver suggested to readers that with recent sob stories about bank failures and the inability to compete, the same sensitivities are being appealed to that originally opened the way for the McFadden Act

Q: I can see where Mr Silvers might prefer to not have the competition of federally

charter banks

A: I wonder if there is such a thing as an unbiased viewpoint We cannot escape our

backgrounds and we shouldn't deny our legitimate interests

Q: Anyway I thought some commercial banks were already dealing in securities

A: Although commercial banks have been allowed to underwrite government guaranteed

mortgage-backed securities, such as Ginnie Maes, they haven't been able to touch CMOs,

as far as I know

Q: What's a CMO?

A: Sorry CMO stands for collateralized mortgage obligations CMOs are bond-like

securities backed by a pool of mortgages whose cash flows are repackaged to obtain securities of mixed maturities CMOs allow investors and underwriters some protection against prepayments by mortgage holders If Congress won’t let them compete more freely, some banks may simply give up their banking charters so they will be free to diversify into other businesses

Q: Many of the nation’s largest banks have applied for an expanded role in the

underwriting of securities

A: Underwriting involves purchasing securities in a block from the issuing corporations

and selling them in smaller denominations to a variety of investors

In contrast to Mr Silver, Federal Reserve Chairman Alan Greenspan believes commercial banks need more latitude in order to compete against freewheeling foreign institutions and Wall Street firms and therefore hopes Congress will overhaul Glass-Steagall

Q: I've just got to tell you about a piece I read last summer in the August 26, 1991 edition

of the Wall Street Journal It was an article by Alan Murray in which he discussed the

antiquated way we handle Treasury auctions in this country Did you see it by any chance?

A: If I did, I don't recall it

Q: According to Mr Murray, the government securities market has always put the dealer

above the customer In the past Treasury has entertained fears that it might hold an auction and no one would show up It was soothing to know the dealers at least, would bid in every auction

A: You mean someone at the Treasury Department is actually afraid the U S

government might offer securities for sale and there would be no takers? Give me a break!

Q: That was Mr Murray's point Such assurances are absolutely unnecessary in this age

of instant global communication He agreed there is no possibility that the U.S government would be unable to sell its debt and therefore why do we need and pay for the expensive services of the forty primary dealers—a n outdated luxury that should be phased out He suggests we examine ways to improve the efficiency of the market, reduce the cost of financing the government's huge deficit so the taxpayer can have some relief

A: I think I might have read the article, now that you mention it Didn't it have something

to do with the Salomon Brothers scandal?

Q: That incident was supposed to be the catalyst for a rethinking of the auction system

controlled by the forty licensed primary dealers

A: Actually anyone can place competitive bids, but the bidding process is so cumbersome

that few outsiders do it The common bidders and large mutual and pension funds, route their bids through the primary dealers This gives these forty dealers valuable information about how the large institutions are going to bid and is in itself a temptation to abuse, according to Mr Murray We take time to fume about underwriting by banks and ignore the manner in which over two trillion worth of government securities is auctioned every year

Q: Let me see if I've got this right The Glass-Stegall Act prohibits banks from being

principally engaged in underwriting ineligible securities

A: Right But to show that they are not principally engaged banks have proposed ceilings

to demonstrate that underwriting in no way makes up the principal part of their securities activities

At the end of 1986 the New York Banking Department, ignoring the old Glass-Steagall arguments that suggested the largest banks, if not severely restricted, could end up controlling industry, decided both J.P Morgan and Bankers Trust New York could underwrite corporate equity and debt, commercial paper, municipal bonds and other activities formerly the sole province of the investment banker

Q: I bet investment bankers loved that!

A: They claimed the state’s action would result in depressed underwriting profits for

everyone and that new investment banking talent would be that much harder to attract

Q: And more expensive! Do you happen to know what is meant by the term universal

banking?

A: Universal banking is practiced in European countries, most conspicuously Germany,

where banks are allowed to take unlimited equity positions in other companies Japanese banks are only allowed a five percent equity share By contrast, American banks are not allowed to engage directly in non-banking activities because their deposits are insured by the federal government and that would give bank-owned enterprises a distinct advantage over independently owned and operated entities The market would eventually see to it that all businesses in the country were owned by banks

Q: It sounds like a choice between bank-controlled capitalism and stock-controlled

capitalism It also seems like Treasury's plan to allow banks to affiliate with non-banks under a common holding company is a taste of the former

A: Not at all, because under the administration's plan, the affiliate would not be protected

by deposit insurance and fire walls would be erected

Q: In his Commonwealth speech, did Mr Rosenberg specify other regulations that he felt

were especially anti-competitive?

A: He mentioned regulations that put a cap on the returns banks can make for

shareholders and the limits on the kinds of products and services banks can offer consumers He suggested a repeal of the restrictions on interstate branching and reiterated the need for a recapitalization of the Bank Insurance Fund (BIF) within the Federal Deposit Insurance Corp (FDIC)

Q: Did he volunteer how he might like to see the recapitalization come about?

A: Nothing really that we didn't already hit on in our discussion He cautioned against

increasing the premiums to such a degree that marginal banks would be unable to pay and healthy banks might find their earnings too severely decreased

Q: I believe the Bush administration is loathe to decrease the profitability of banks via

high insurance premiums and capital requirements I've read elsewhere that for every dollar a bank pays in premiums to the FDIC, fifteen dollars are removed from its lending inventory

A: I think Mr Rosenberg mentioned something like that also He advocated a free market

in banking which would, he said, give consumers a wider choice of financial services and products at competitive prices than anything dreamed up by legislators

Q: Not only that, there's safety in the diversity now prohibited by Glass-Steagall

A: Absolutely As we said earlier, there's safety in geographical as well as investment

diversity

Q: According to Randall Pozdena, in an article for the Federal Reserve Bank of San

Francisco Newsletter, there is a difference between the way leverage is viewed and used

by private corporations and the banking industry In a corporation, increased leverage (greater debt to equity) raises the expected return (earnings per share) to shareholders which makes those shares more valuable On the other hand, reliance on debt weakens the private firm’s ability to survive fluctuations in asset value without default and subsequent bankruptcy

A: Of course tax policy distorts the picture somewhat since interest payments on debt are

deductible against corporate income and dividend distributions whereas retained earnings are not

Q: I've heard that most U.S banks are already overcapitalized relative to the risks to

which they are exposed

A: A bank has an incentive to either guarantee all of a loan or to retain the loan and the

related exposure Therefore, while there may be far too much capital in the banking

system as a whole, there may be far too little to protect the FDIC from experiencing catastrophic losses in a severe nationwide recession According to financial consultant Lowell Bryan, having everyone raise more capital is not the answer The problem lies with specific institutions, not the entire industry

Q: As you yourself have said, Congress has over and over again shown its propensity for

blanket legislation rather than targeting needs The problem is the commercial banks would be risking depositors’ money As legislators see it, the challenge is to restrain the enthusiasm of bankers and see that their greed is tempered with good judgment in order

to avoid results similar to those which came from their earlier plunges into real estate, energy and overly optimistic loans to lesser developed countries

A: The third phase of the Depository Institutions Deregulation Act of 1980, loosening

restrictions on banks and savings and loans, was set to take place in 1984 However it was overshadowed by a proposal from the Task Group on Regulation of Financial Services which was headed by then Vice President George Bush

Q: What proposal?

A: The plan announced in late January 1984 was to replace the comptroller's office with a

newly created Federal Banking Agency within the Treasury Department It would have had jurisdiction over most of the then 1,425 federally chartered banks and their parents

Q: What do you mean most? Are there some banks they wouldn't have controlled?

A: The fifty largest bank holding companies would have continued under the jurisdiction

of the Fed which would have also acquired jurisdiction of the nine thousand chartered banks then regulated by the Federal Deposit Insurance Corporation The Fed could have certified individual banks and release them to the jurisdiction of state agencies

state-Q: I never heard about this

A: The gang on Capitol Hill kept it from seeing the light of day

Q: Well, I'm grateful to those who blame deregulation for the massive savings and loan

bailout and banking troubles that loom over taxpayers today What do you think?

A: I'm always for as little regulation as possible and more decentralization of power But

when institutions do a lousy job regulating themselves, government steps in Regulating

is the easy part; everyone loves to tell everyone else how to act The hard part is deregulation A lot of people have a stake in maintaining federal and local regulation Deregulation on the other hand, is like moving a mountain

Q: John F Kennedy gave deregulation a try when he was president

A: But it took the OPEC created inflation of the 1970s to give it any kind of momentum

In the seventies the airlines, trucking and finally financial institutions were deregulated

Q: I thought Regulation Q was in effect all during the seventies

A: Regulation Q was a prime example of unhealthy interference by government If you

remember, banks, under Regulation Q, were only permitted by law to pay five to five and

a quarter percent to depositors when the prime [most favorable interest rate] was as high

as twenty-one and a half percent! Inflation meant that savers were getting less real dollars back than they put into the banks in the first place Usury laws kept credit cards at eleven

or twelve percent in some cases when borrowing elsewhere cost eighteen to twenty percent

When deregulation overtook Regulation Q it was way overdue Restrictive monetary policy had driven interest rates up and depositors had left banks for higher-yielding, unregulated money-market accounts

Q: When was Regulation Q dismantled?

A: The interest rate ceilings imposed by Regulation Q were removed in 1982

Competitive banks immediately began paying depositors interest rates far in excess of the risk assumed

Q: Risk assumed? With deposit insurance, there was no risk assumed

A: That's the point Government in effect subsidized those interest payments to

depositors and allowed the banks to offer overly generous loans to borrowers

Q: They could do that because technology had allowed them to raise deposits around the

world and they were unable to use those deposits for anything beyond the loan business

A: That's right The Glass-Steagall Act still keeps the big commercial banks from

underwriting corporate securities in this country and competing with the investment bankers If a transaction is successful the bank is often able to make money from the management fees and also from the profit on the deal itself The difference between the additional-fee-income and interest-income alone explains why investment banks enjoyed

an average return on equity of twenty-six percent 1983-1985, while commercial banks had to settle for an average return of fourteen percent But these off-balance-sheet deals stretch the bank’s capital in ways the traditional ratios fail to measure

Q: No wonder they sought high returns through high-risk lending to Third World

countries and to commercial real estate developers

A: You're right The discipline of a free market was removed and speculators had a field

day

Q: Most politicians tell it the other way: regulation was removed and speculators had a

field day They still haven't realized that government regulations cannot control market forces Government regulations just mess things up

A: The trouble is, when one speaks of market forces in financial matters, one better be

prepared for booms, busts and their accompanying panics The debate should not be whether we rely on regulation or markets—history shows unregulated financial markets self-destruct Problems arise when we try to use regulation to control market forces that are beyond its control and in the process create flaws that skew the marketplace

Barney Frank of Massachusetts is, in my opinion, one of the most brilliant men in congress He showed that he knows darn well what is going on when he reminded fellow members of the banking committee that:

As you measure something you may be affecting it As you regulate something you may be affecting it We ought not to pretend that the regulation is simply a neutral look Regulation is a calculation of risks We under calculated the risks of lending and under calculated the damages of too little lending—we need to balance the two

Q: It's only too bad that he has more faith in the ability of inexperienced legislators to

calculate risk than he does in experienced bankers and investors He obviously prefers regulating to market forces It seems to me that congress, instead of reforming the deposit insurance system, is simply increasing the power of regulators and examiners to determine who gets credit and who doesn't

A: You're right When the losses from depressed real estate are tallied it is possible that

40 percent of all deposits will be in undercapitalized institutions Therefore how these deposits will be lent will be controlled by regulators rather than management and shareholders Naturally each participant will find ways to exploit the particular rules that apply to him or her

Strong banks will search for loopholes in Glass-Steagall and for states that will allow them to do things not allowed by federal law Non-bank financial firms will continue to sell bank-like products (money market mutual funds, credit cards, home equity loans) with a different set of rules Instead of making market and economic and competitive forces work better, this narrow reform will distort those forces It won't be the quality of service that gains market share, but exploitation of rules

Q: It has recently been suggested that instead of reviving Regulation Q with its inflexible

ceiling on interest rates, that maximum interest rates on deposits be raised to the market interest rate on Treasuries What do you think?

A: As long as legislators are determined to dictate to the market this proposal would at

least avoid the drain on banking that occurred under Regulation Q whenever the market rose above the old inflexible mandated rates

Q: The average citizen has been pretty much brain-washed by media coverage and

almost to a man and woman believes deregulation has been the cause of most of our problems and must at least share the blame for the recent instability in the U.S financial system They honestly believe that deregulation encouraged banks to venture into risky activities that they often knew little or nothing about

A: I grant you, the present trend is away from removing regulatory oppressions and

toward the imposition of new safeguards aimed at ensuring the safety and soundness of the banking system

Q: Now who could be against “ensuring the safety and soundness of the banking

system”?

A: Exactly! Deregulation is a chicken or the egg question Which is the cause and which

is the effect?

Q: For you maybe—but as I've said, I think it is settled in the minds of most citizens and

deregulation has been awarded the black hat!

A: Did you know that Islam forbids the payment of interest? They have a profit-or-loss

system where the borrower and lender make an agreement that delineates the way in which profits or losses are to be shared between the two parties

Q: Sounds like an equity position where the lender becomes owner of the venture by

agreeing to share in losses as well as profits

A: That's an interesting way to look at it I like the fact that risk is transferred to the

lender, which makes the lender more careful about the endeavors it finances This emphasizes productive investments

Q: That makes sense I would expect lenders to become involved in a venture where they

have placed money and to do their best to make it work They essentially become team players

A: The banks' balance sheets would show equity positions on the balance side and the

liability side would look like a listing of shares in a mutual fund Instead of depositors, there would be shareholders and their returns would vary with the banks' returns There would be no need for deposit insurance and no fear of runs on the bank

Q: It is doubtful that the banks would have so easily lent money to LDCs if the return on

the investment depended on the success or failure of the project for which the money was requested

A: Also if depositors viewed themselves as investors with money at risk, they would

shop in order to put their dollars in the bank with the highest profit and least risk Sound management would be rewarded and encouraged

Q: And banks would be forced to find the most promising investments in order to attract

depositor-investors

Hey, do you think we've hit on something? Do you think America's commercial banks should forget about earning interest and become equity-based financial institutions?

A: I realize you're joking, but I really think a trend in that direction should be

encouraged An interim suggestion was tendered by Mohammed Alacem, associate professor of economics and Middle East editor of Economic Forum in an article

published in the May 9, 1991 Wall Street Journal:

Depositors could make standard deposits that are federally insured up to a reasonable limit or could open an uninsured mutual fund account Allowing financial institutions to play a dual role would give a much larger sector of the U.S population access to mutual funds The exposure of the (FDIC) would diminish as more depositors become more savvy and open accounts in the mutual-funds side of the bank

Q: That would stifle the entrepreneurial spirit

A: What do you think tight credit does to the entrepreneurial spirit? Since marginal

projects would not be easily financed, there would be fewer failures A little caution should not be the death knell of the entrepreneur It could help to ensure a greater

percentage of successes, which ain't all that bad!

Q: A great theory but …

A: Ok, I admit there are abuses

Q: Sure, instead of making interest on a car loan, the Islamic bank purchases cars

outright and sells them to would-be-borrowers at a profit If payments are made in installments, this is merely a disguised interest payment

A: There are no perfect solutions but I think we should be looking for new and better

ways to do things I'm not advocating wholesale adoption, but we can pick and choose from a variety of ideas to upgrade our present system

Q: I agree that we can't afford to be complacent when in FY1991 the FDIC paid out

$66.6 billion and is expected to disburse $100 billion or more in 1992

A: Add on the seventy billion loan to the BIF (Bankers Insurance Fund) and there is a

liability of two hundred and fifty billion in future outlays just to pay off depositors

Q: That's what I mean There are no constituents for this item in the budget Everyone

would like to see it fall to zero

A: Falling real estate values will trigger more failures by thrifts, banks and insurance

companies Depressed real estate values lower the value of loans and securities collateralized by real estate which represent about thirty percent of bank, insurance and other financial institution portfolios

Q: Not to mention that real estate makes up one third of household net worth and

contributes in varying degrees to the net worth of businesses

A: Don't overlook the fact that commercial real estate is responsible for about

twenty-three percent of all the taxes paid in this country

Q: More than seventy percent of all local taxes collected

A: That's right Real estate values have an enormous impact on every community

Q: Furthermore, as far as I can tell, every economic recovery in the post war period has

begun with real estate This is serious stuff! How did we let this mess happen?

A: There's no one thing or person to blame, but it's fair to say the 1981 tax cut created

excessive incentives which contributed to the overbuilding of commercial real estate

Q: On the other hand, the 1986 act overshot and knocked the props out of real estate

prices by taking risk capital out of the industry

A: That's right Then some people claim inadequate regulation was the cause of the

over-aggressive lending which led to inflated prices and overcapacity

Q: Enough with the problems and reasons What's the cure?

A: We need to stabilize real estate values to prevent the failure of more institutions Q: How?

A: To get the industry moving again I believe we need a combination of lower interest

rates, regulatory policies that allow sound real estate financing, and a federal tax program aimed at stabilizing and restoring commercial and residential real estate values

The Fed has been attempting the first step by lowering interest rates but long term rates need to come down further

Secondly some of the lavish criticism that has been directed at both lenders and regulators needs to be curtailed The constant blame has led to paralyzing fear The Fed and regulators should assure lenders they will not be penalized by financing sound real estate investments

And hardest of all, because next year is an election year and partisan politics will be in full swing, congress should restore some form of passive loss treatment, cut the capital gains tax and expand incentives for low-income housing

Q: I'd advise some caution there Existing commercial properties should be favored over

new construction—for residential there should be incentives for new construction

A: Stopping the decline of real estate would restore confidence and health to the capital

markets

Q: The inevitable question—cost?

A: What such a program would cost in foregone taxes would be made up in fewer bail

outs Shortly after the passage of the 1991 FDIC reform act, Timothy Ryan, head of the RTC [Resolution Trust Corp.] told examiners not to write assets down to liquidation value

Q: I bet that didn't sit well with Henry Gonzalez, chairman of the fifty-one member

House Banking Committee

A: You're right about Mr Gonzalez wanting to counter this go easy approach he felt was

being urged on bank examiners After all, congress had just passed rigorous regulations, not geared to help Mr Bush's re-election, so it is likely that Mr Gonzalez thought members of congress were kept from the Baltimore meeting of bank examiners, which took place at the end of 1991, for partisan reasons

Q: I've observed his banking committee in action and it is evident that Mr Gonzalez

wants to see full disclosure of any banking industry problems He believes the practice of sweeping problems under the rug, is what led to the current Savings and Loan fiasco He has gone on record as anticipating a banking crisis in the 1990s to mirror the Savings & Loan crisis of the 1980s

A: That's right He advocates early intervention and prompt takeovers His zeal can, in

my opinion, be dangerous and lead to premature and unneeded bank closings

Q: You've got to admit there were an inadequate number of regulators in the Ronald

Reagan cut them back and went to off-site monitoring using computers and other technology

A: Joel McLemore, was an FDIC examiner from 1976 to 1986 He wrote an article

published in the Wall Street Journal on December 5, 1991 He revealed some of the

temptations, and often shady practices, of bank examiners on their way to the top of their profession Bucking for a promotion led to some over zealous determinations He suggested that most field offices have at least one hard-nosed examiner who put the burden to prove asset quality on the bank

These examiners enforce exacting standards that few banks can achieve While one excessively ambitious examiner in ten might not sound like much of a problem, bear in mind that these examiners seek to do more examinations than others

Q: When a few large, mostly adequately secured, real estate loans are classified as

substandard, even though risk of loss is minimal, the perception of the public and legislators is skewed Unfortunately individuals, companies, and in this case bankers,

simply sit back and take it from their government The feeling of powerlessness against

government is becoming all too pervasive in today's society That's why I like the prescription Mr McLemore proposed for bankers

A: What was that?

Q: He said:

Few banks bother to contest inaccurate [loan] classifications on the mistaken assumption that such protests are futile…a thoughtful proof that a classification was substantially incorrect will receive consideration That proof might be sufficient to preclude some forms of corrective action, as agencies are sensitive to charges of unfair practices

A: I want to take a minute to relay an example of what is going on in this regard by

referring to an article by Daniel Clemente, a real estate consultant in Virginia, which

appeared in the November 4, 1991 issue of the Wall Street Journal Mr Clemente told

the tale of a real estate development started in 1986 and aborted in 1990 after the first phase of 318 homes had been completed Mr Clemente was a consultant to the bank which acquired the uncompleted portion of the project in the spring of 1990 His firm determined that to maximize the return on the sale of the land, it would be prudent to complete the engineering work This would enable us to obtain final site plan approval for the subdivision of all land in phases two and three into building lots .because the approval process is so lengthy, taking property to final approval adds great value to the property

The bank was advised to complete construction of the sewer line but before this could be accomplished the RTC took over the institution and decided not to go ahead with any work on the described property Consequently a year later the RTC (taxpayers) held 213 acres of land with no access to sewer lines which will have to be marketed as acreage rather than lots

In the meantime the preliminary plan approval granted by the town is about to expire Since the original preliminary plan was approved, the town has altered its design standards for public facilities Engineering to meet the new design standards will cost an extra $440,600—money that could have been saved had the RTC finished the job back in

1990