Regional President Speech

~ (~. ~ ;/ .. .. ~~ .~~ ~ ~f>~a1~7~ ~d ~ 0h Thank you for ~r kNxd- invitation to meet w~t you ~'. We at the Federal Reserve such opportunities to discuss important current issues in banking and the economy witn financial, business, and professional audiences. Given the dynamics of our nation's economy, this is a particularly challenging time for us in the Federal Reserve, not only because of our monetary policy responsibility, but because of our role as a r~~of banks and bank holding companies. ~1: h:yan~ intend to wear my bank regulator' s to focus on current banking conditions and on some of the lessons to be learned from this period of stress among our banks. This topic seems quite timely in light of constant he adli nes about banking problems that have generated public concern about banking stability. But because the broad performance of the economy has a great deal to do with the performance and ultimate stability of financial institutions, I want to comment first on the economic situation and outlook. situation~whether As observers of the economic we are policymakers, . bankers, or interested business and professional , geople, we are confronted now with economic crosscurrents tnat cause considerable uncertainty about the outlook. On the positive side, for example, we see that stock and bond prices are reaching new hi9hs.! Interest rates are down to levels not seen for eight years, and the value of the dollar is down sharply in the foreign exchange markets. Oil prices also have -2­ -~, declined sharply~to mid-1970's levels, helping to cause declines in consumer price indexes in recent montns. And, tne:e are none ~ of the s igns of recession t hat might nave been expected after ..-- (fo.JL 0'"I0W 'A~. some three~r~f business expansion. On th~' other side of the ledger, though, recent good news may have obscured the fact that our economy nas been sluggisn over most of the past two y e a rcl. Growth in industrial production and u.s. e xports has been very weak. Even our consumers, who led the ~ way with strong spending earlier in the expansion, appear to be ta~ing a breather, as evidenced bY 3 eak retail sales!and/slower auto sales. Moreover, there are, as you know, near depression- level conditions in our a gr iculture and energy industries, accompanied by energy-belt problems in commercial real estate. Along with these crosscurrents that muddy tne economic un~ertain waters/ the outcome of current public policy de bates ~-,,;.. . furthe complicates the outlook. For example, what ~likelY ~ f>U effectS" on tne economy of pending decisions to 1 ? •• " ,Jet:>, ~- reduce the federal budget deficits? How are reforms to our tax ~ system going to impact consumers' and businesses? At this point, we have no defini~n~ers to these questions. s~all~ However, as I positive and negative elements as well as the unknowns, I conclude that th~on'~Onomy should experience good growth this year an5iinto 1987~enCouraged by declining oil prices, lower interest rates, and an improved trade balance resulting from a lower dOllar .1 I hope my is ~corr t'w becauB~~esolution of many of the problems - . ~40.z:A4h:... in ou /ij1l~Y1epends on the healtn and growth of the economy. -3­ Unfortunately, even a generally positive economic outlook may provide little comfort to the many banks that have taken it on the chin with farm, energy, and r eal estate loan as well - , . =a::;:;: Qfoble~ as ongoing troubles with the debts o~less developed countries. These high-profile problems have drawn considerable attention from regulators and have weakened public confidence in b~~ . ~ Thus, with these issues in mind, I want to focus on steps that can bolster public confidence in our banking system. First, I want to briefly review our r~gional banking situa~ion,;I , then discuss what the Federal Reserve is doing to promote banking stability. Finally, I want to draw from our regulatory observations of recent years to suggest what bankers themselves can do to contribute to a sound banking system. In supervising state member banks and bank holding companies ~ the Federal Reserve has had a firsthand look at banks' problems throughout the nation. Despite strong first-quarter earnings reports from major banks in recent weeks--based largely on -bond ~arket p rofits ~d hea~ier interest margin spreads,~e all know that the problems of LDC debt and farm, energy, and real estate loans have not evaporated. Ongoing problems are clearly evident in our own region. The Tenth Federal Reserve District that we serve at the Kansas City Fed continues to experience some of the most severe banking conditions in the na~ ~55 of the nation'-s -12­ 0 bank failures occurred in ~. Three of our states--Kansas, Oklahoma, and Ne braska--had 13 failures each. And with the existing conditions in agriculture and energy, the environment ~ continues to be troublesome f0.:...Abanks. y fl -4­ standard bank performance measures clearly document the ~ situation. For example, the average return on assets f~banks rI ~ in the District is only about one third its level Af ive years ago, ~, ~ primarily because c-redit quality has decreased. Net loan losses - as a percent of total loans have increased nearly five-fold since 1980. Banks' nonperforming assets have shown a similar and dramatic increase and now average over~ 4 per cent of ~ loans at banks in the District. Fortunately, bank capital has risen somewhat since 1980, but these levels may be difficult to maintain in the face of increas~an losses. Overall, in a region where bank performance once exceeded national averages, bank performance now trails the averages in many measures. Despite this difficult situation, let me e~p~~~:JrnlY a small portion of banks in the nation and reglon severe - < ,,-­ banks in the region had negative earnings last year, most of .......... ill ---..-' these losses were not large enough to significantly affect bank capital or to threaten the viability of these banks. Moreover, although fewer banks are doing as well now as in previous years and some are losing money, the vast majority of banks in the region are still s-ound, profitable institutions. In terms of return on assets, -half of all our banks earned .74 per cent in 1985, and one-fourth had an ROA above 1.16 per cent. These are good, if not excellent returns, given the environment. with that brief look at our now to tn~ Feder~ser,~el~':t 2,.jcurrent problems and outline the steps "g to help stabilize tne ~ ar~ environment. As a Reserve Bank president, I have two perspective's. One emphasizes the Federal Re~~s role as - ~ 0;:,...; lender of last resort and monet~~ke~ ~.~~ an~e rbi~y inte"est in the stability of tn 'system of banks to cope with a changing marketplace. The other -- perspective focuses on our sensitivity to the need to maintain communities. ~ ~~. effective banking services in all kinds of In considering these issues r~cently at the Kansas City Fed, ~es we determined that one of is "to respond to problem situations with an appropriate balance of supervisory finan~f~to stable~ action and professional and assure a environment." This objective is with a number of steps ~ liR~ the Federal Reserve has taken recently to better identify and respond to banking problems. Three of these actions are an expanded supervisory program, a capital forbearance policy, and a P~~isk-based bank capital..~~'''U ~f these steps, the expanded supervisory program, was announced late last year. This program seeks early detection of individual bank problems through more frequent on-site examination~particularlY ~ge institutions. If problems ~ are found, we then CI"•• liiiiilil. monitor the bank or holding company more intensively until the problems are resolved. The program more effective communication of our examination findings to the management and directors of institutions with significant problems. -6­ .. actionJ in response to the current banking ~~~~~~~~ ~. ~ ~ - .r er.vironment~ the Fed and other bank regulators announc~ Marcn~ a capital forbearance policy. Tne policy is intended to assist sound farm and energy banks facing temporary ~~s/ ~n~ banks~~be capit~belo~nimum allowed to operate with standar~g4a~h:';"_~~ ~~a5e plan to restore capital ~ 6-1f 'C.he~ to control e}c.penses. In adai'C.ion, tne ... .... ~ t.;;;;~ Federal Reserye.will continue to allow banks to restructue~ loans ~~ Withori~.... aut6 matic chargeoff~ so long as tne restructuring ~ An~ so consistent with generally accepted accounting principles. ) long as borrowers are meeting the new loan terms, the loans no ~L~ longer Wil.llb~ted as nonperforming.~ . ~hird now under consideration by the federal bank regulators is a proposal f~ ~~~~~al' risk-based capital standard. This standard w~~easure tne i~aPital risk in a bank's portfolio in assessing needs. Compared to current capital policies, the risk-based measure would better address off-balance-sheet exposures and temper existing incentives for banks to reduce their liquid assets. In another arena, the Fed to Congress that ha~Ug~ested ~t.~ current interstate acquisition ro be expanded to include isi~ns allow failed ban~~~3~~nce!.~~/:~:},;:.on in ~sets and to ban~o be'~~red ~ problem before they ftail. Although supervisory policies can indeed help banks achieve s~ ~weatner operations temporary economic turbulence,/ tnere is no question that the fundamental responsibility for a bank's condition remains with its management and directors. The actions -7­ ~ I~just described reflect this reality because tney are designed to provide time for basically sound institutions to correct tneir ~ -- ~ problems. These actions will in no way help hide problems at superViSOrYA~ troubled banks or delay any needed internal or Now that the regulators have strengthened tne potential for many troubled banks to regain full health, it given time, it is appropr iate ..",., to consider some of tile lessons oi j:.nis diiiicult superViSOry ~s: period. Drawing on our recent tnere are four b~ic l essons or principles~f banking practice wnicn, in ~ our view, seem to separate good banks from problem banks. The first, and perhaps most valuable less on of tOday's{ ~ -r;; - i:i:-~ C-L{ -:/ environment is that success~er~reCOgniZe the cyclical nature of many industries ~~vide for the ultimate downturns. In contrast, banks with severe problems today nave typically operated as if prosperity is a constant factor.~ ~~~. Unfortunately, a good example is the current decline oi agriculture. Historically, farm income has fluctuated considerably. The current period, in fact, is far from unique. Two previous boom-bust peri~ds in tnis century displayed similar ~--J .. magnitudes and patterns-rincreased world demand for U.s. farm products, rising farm income, land env~r0.nment, SUbs~...:.clining demand, an~col Tnus, expe~n~d bias rural bankers toward caution. Moreover, it seems clear that bankers cannot afford to s--p--eculate .. on boom conditions in cyclical industries. A -second basic principle that flows from our recent supervisory observations is that credit concentrations must be ~ b -8­ avoided whenever possible. Loan concentrations leave banks hignly vulnerable to problems in a single industry--wnetner agriculture, energy, real estate, or video games. Too o~l~~~ ~ n ~~ loan concentrations are achieved by relaxing standards. The Penn Square failure in Oklahoma City is a prime example of what can happen when a bank's single-minded pursuit of one typ~ of customer is combined with lax lending policies. As you will remember, Penn Square Bank generated more tnan ~~ energy loans--about . e the bank's assets--largely through tne efforts of one lending officer. Equally astounding is the fact that this shopping center bank was able to sell many of these o~~~c;~view, loans, with little documentation to several major U.S. banks also obsessed with energy lending. Although Penn Square is admittedly an extreme example, tnis case is a strong reminder that banks should try to avoid tying their future to a particular industry or group of customers. Banks which cannot escape business concentrations/ -and banks in rural areas face this situation/ -should compensate for the risk with higher credit standards and capital levels. A third principle observed from recent experience is tnat any type of banking risk, whether from loan concentrations or other sources, should be backed with adequate caEital protection. Bank stockholders--not depositors or the FDIC--should bear tne risk. If risks are justifiable, adequate compensation should be built in through higher earnings potential. Banks in our region, because of their size and tne marKets they serve, have traditionally maintained higher than average -9­ now ~ capital levels. This extra capital is banks tne ~, agricultural~. resources to weather the However, we have observed that many of the banks with more severe problems today followed strategies that carried above-average risks. Wi~ simple hindsight we also see that these banks generally," t ~ no better earnings than their peers. Taking higher risks has not provided the earnings to cushion each bank's downside exposure. A fourth lesson f rom our recent supervisory observations is .­ that banks should avoid so-called "one-man shows" where directors .. and committees are simply rubber stampers: FDIC studies confirm that a weak and disinterested board of directors is a common thread in most bank failures. Indeed, the five largest failures u.s. in history were characterized by a concentration of power in one or two individuals concerned only with rapid expansion. We know that successful banks benefit from broad input and guidance. ~ There is no magic in any of the four principles I hav~noted, iS~ist nor all-inclusive. For example. some .III!JiI1&- wo uld mention a traditional aversion to £gt-of-territory lending r~ other sound banking practices as being just as important. ~et me summarize:/ the current troubled environment for banking is testing individual banks' operati~ practi ces an~ Though the supervisory agencies have taken steps to principl~. maintain stability and ease subsequent adjustments in banking, the primary responsibility for sound banking continues to rest with a bank's management and directors. The f e ur lessons or pr~ciples that I mentioned are but - traditionaJL~delines for successful banking which are well -10­ understoo~ most bankers. But it is clear to us at the Fed that the current difficulties of almost every proolem bank can be ignOring~ne mo~rinciPles. traced to the or Adherence to the basic principles of sound banking can help shield banks from near-term problems while, at the same time, positioning tnem to better withstand future downturns. Let me say in conclusion that we at tne Federal Reserve will do all we can to promote the sound, traditional principles of banking that will help prese~~c confidence in our fi;ancial system. And let ~assure you tha7' in tne interest of overall economic stability,/ the Federal Reserve will continue to pursue a monetary policy course that contributes to a climate of moderate non-inflationary growth in which banks~and all kinds of businesses1 for that matterJ'-can compete and prosper.

J. Roger Guffey (1986, April 28). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19860429_j_roger_guffey

@misc{wtfs_regional_speeche_19860429_j_roger_guffey,
  author = {J. Roger Guffey},
  title = {Regional President Speech},
  year = {1986},
  month = {Apr},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19860429_j_roger_guffey},
  note = {Retrieved via When the Fed Speaks corpus}
}