Regional President Speech

BANKING IN TRANSITION: LESSONS FOR THE FUTURE Thomas M. Hoenig President Federal Reserve Bank of Kansas City Wyoming Bankers Association June 13, 1992 The credit crunch continues to draw national attention as we contend with the slow pace of economic recovery. This crunch has been blamed on a variety of factors–overzealous examiners, reluctant bankers, and recent actions by economic policymakers. However, like most previous credit imbalances in the U.S. economy, the origins of the credit crunch extend back beyond the last few years, back to events and policies that had intended positive effects, but also led to unanticipated and notable problems in the economy and the financial system. Today, I would like to look back on some of the major legislative, regulatory, and economic events of the 1980s that systematically affected credit funding and allocation; and from them I would like to suggest some lessons to be learned. These lessons are of particular importance as we now begin implementing a new banking bill, the Federal Deposit Insurance Corporation Improvement Act of 1991, which incorporates substantial banking reform. Setting the Stage The 1980s began with high interest rates, high inflation, and a difficult recession. Because of deposit interest rate ceilings, banks and thrifts could not pay rates on many deposit categories that would be competitive with less regulated institutions. In addition, thrifts and other depository institutions with significant amounts of long-term, fixed-rate loans were suffering substantial depreciation on the loans they had made during periods of lower interest rates. The economy had no momentum. Everyone seemed to agree that something was needed and a number of legislative initiatives to address matters were soon enacted. The first of these initiatives was the Depository Institutions Deregulation and Monetary Control Act of 1980. This Act sought to diminish regulatory differences across depository 3 institutions to make them more competitive. The Act gave banks and thrifts more flexibility in setting rates on deposits, and gave thrifts the opportunity to invest in a broader range of assets as a means to decrease their interest rate exposure. More notable provisions of the Act included: • Six-year phaseout of interest ceilings on savings and time deposits at insured institutions; • Increase in deposit insurance coverage from $40,000 to $100,000; • Expansion in federal thrift lending powers in the areas of nonresidential real estate, consumer, commercial, and agricultural lending. This legislation was step one in setting the stage for today's credit crunch. It not only gave banks and thrifts more flexibility in setting rates on deposits, a needed objective, but by dramatically increasing insurance coverage, it also gave weak institutions the undisciplined ability to attract large quantities of funds quickly. The 1980 Act thus provided the fuel for bank and thrift asset growth. Following these changes came the Economic Recovery Tax Act of 1981. This Act was adopted during a period when high interest rates and inflation had disrupted a wide variety of investment activities, including real estate investment. In fact, the overriding and stated purpose of this legislation was "to encourage economic growth through the reduction of the tax rates for individual taxpayers, acceleration of capital cost recovery of investment in plant, equipment, and real property, and incentives for savings." This Act, by lowering tax rates, gave a boost to disposable income, consumption, and debt and equity investments. These were important and desirable changes as they encouraged significant increases in economic growth and activity. However, the Act also significantly shortened depreciation periods and allowed a more accelerated rate of depreciation based on other than the 4 economic life of the project. This favorable treatment was most obvious in the case of real estate investment. Real estate depreciation periods were cut in half on average, and with accelerated depreciation rates, far more depreciation could be taken in the early years of a project. These changes thus substantially increased the after tax returns in real estate and laid the groundwork for the subsequent surge, some might say excessive surge, in real estate activity. And finally, the Garn-St Germain Depository Institutions Act of 1982 was passed. Much of this Act represented an attempt to revitalize the housing industry by strengthening thrifts and other housing lenders that suffered serious problems during the high interest rate environment of the previous few years. Notable provisions of this Act included: • Creation of an insured Money Market Deposit Account, which gave banks and thrifts the ability to compete for smaller accounts on a basis competitive with less regulated institutions. • Authority for federal thrifts to place up to 40 percent of their assets in nonresidential real estate loans and to further increase their consumer and business lending. • Removal of certain prudential loan-to-value restrictions on real estate lending by national banks and federal thrifts, thus encouraging a lending binge by aggressive institutions on projects with little or no equity backing. A reason cited for expanding thrift lending powers was, ironically, the higher earnings that had been reported on nontraditional activities by state thrifts in Texas. Many states that had not yet adopted such powers soon gave their thrifts powers that equaled or exceeded those at the federal level. Furthermore, the purpose of removing certain lending standards for national banks was "to 5 provide national banks with the ability to engage in more creative and flexible financing, and to become stronger participants in the home financing market." The Credit Boom Thus, the stage was set. These legislative initiatives encouraged significant new investment in the economy focusing, for example, on commercial real estate. They encouraged banks and thrifts to meet the expanding need for credit through imaginative and innovative credit programs. However, these initiatives also had some unanticipated side effects. The year 1981 marked the beginning of a long expansion phase in the U.S. economy. The 92-month expansion between 1982 and 1990 represented the second longest expansion phase since World War II, exceeded only by the 106-month expansion during the 1960s. As this expansion phase continued, consumers and businesses formed ever more optimistic assessments about the economy and became more willing to take on heavier debt loads in relation to their incomes. Real estate, consumer, and corporate debt all greatly outpaced the growth of national income during the decade. Commercial real estate -- which received extremely favorable treatment under the 1981 Tax Act -- showed the most rapid growth in lending. In the case of banks, for example, real estate loans rose from 14 percent of total assets in 1982 to 25 percent in 1991. This lending boom and the associated tax incentives were so great that commercial construction far exceeded the economy's need for new office space and rental units. Average office vacancy rates in key U. S. metropolitan areas, as reported by Coldwell Banker, grew from less than 5 percent in 1981 to more than percent by 1985. Total mortgage debt and consumer installment debt grew at average annual rates of more than 11 percent between 1983 and 1989. Corporate debt grew by $1.1 trillion between 1984 and 6 1990. Much of this debt grew out of a wave of corporate mergers and buyouts as corporations issued debt to finance buy-backs of their own stock. The retirement of equity exceeded the issuance of new equity by $640 billion in this period. Helping to fuel this growth was the newfound ability of banks and thrifts to raise large amounts of insured deposits with no constraints on interest paid. For example, brokered deposits at thrifts went from $8 billion in 1982 to $75 billion as late as 1988. The Pendulum Swings Back During this credit boom, the economy did as expected -- it reacted to the incentives created and leverage became the theme of the 1980s. Then in 1986 things changed again. The Tax Reform Act of 1986 sought to substantially lower tax rates, simplify the tax code, and provide for more equal taxation of income from different sources. The objective was laudable. However, following the 1981 tax changes, the effects were mixed. The reductions in tax rates had the additional effect of decreasing the need for tax sheltering of income through such means as real estate investment. Also, to bring greater equity into the tax code, the Act set depreciation periods and rates on a more realistic basis than under the 1981 provisions and disallowed the deduction of passive losses against income from other activities. The longer periods and slower rates of depreciation under the 1986 tax reforms substantially decreased the after tax benefits from real estate investment. This effect was further reinforced by the lower tax rate structure and the passive loss restrictions. The effect of these provisions and previous tax changes was evidenced in the level of real estate investment and lending through privately placed limited partnerships -- the type of real estate activity most sensitive to tax provisions. Between 1980 and 1984, the funds provided by this single source increased more than sixfold to $16 billion. However, by 1988, funding had fallen back to the 7 1980 level. Some real estate investors and lenders did not pull back with the change in law, especially west and east coast bankers caught up in regional economic expansions. Presumably, they judged that economic conditions and demand for leased space would offset the negative effects that the tax changes would have on returns. Also in 1986, as the tax laws were being reshaped, problems within banking were beginning to show themselves in a significant way. Not all segments of the bank and thrift industry fared well during the credit boom. This was particularly true for the thrifts that never found a way to recover from the problems of the early 1980s and for banks located in areas experiencing regional downturns. Moreover, many thrift problems in the mid to late 1980s, as well as some of the banking problems, could be tied to the previous legislative changes that led to the growth in brokered deposits, expansion into commercial real estate, and the lowering of lending standards. The expanded thrift powers, for instance, provide an example of legislation with good intentions and a strong rationale behind it that, quite simply, encountered a changing environment and intense competitive pressures to lower lending standards. Falling interest rates after 1982 restored the value of traditional thrift activities. On the other hand, lending excesses by some institutions and overbuilding in many commercial real estate markets adversely affected the thrifts that moved out of traditional activities and into nonresidential lending. A recent study (Benston and Carhill) tends to confirm these effects.1 Thrifts that survived the 1984-1991 period were found to have held on average less than 20 percent of their assets in nontraditional instruments. For the thrifts that failed, nontraditional asset levels generally were 10 to 20 percentage points higher. 1George J. Benston and Mike Carhill, "The Thrift Disaster: Tests of the Moral-Hazard, Deregulation, and Other Hypotheses," a paper presented at the Annual Conference on Bank Structure and Competition, Federal Reserve Bank of Chicago, May 6-8, 1992. 8 In response to these mounting problems, several legislative and regulatory changes were adopted, including the Competitive Equality Banking Act of 1987; Financial Institutions Reform, Recovery, and Enforcement Act of 1989; and risk-based capital standards. The two acts placed a number of limits on the activities and operations of problem thrift institutions, including tighter capital standards and restrictions on certain nontraditional powers and the use of brokered deposits. These acts further led to higher deposit insurance premiums for thrifts and banks. The adoption of risk-based capital standards forced problem institutions to begin taking steps to increase capital levels. Together, these changes restricted the ability of institutions to expand as they had throughout much of the credit boom, and the credit crunch began. The Credit Crunch The credit crunch first showed up as a lower rate of growth in bank lending, but then progressed to an actual decline. Bank loans, after growing at an average annual rate of 9.5 percent between 1983 and 1989, rose by less than 4 percent in 1990 and then showed a decline across much of 1991. For thrifts, these lending declines were even more severe, because of the efforts needed to resolve failing institutions and bring more capital into other institutions. Thrift lending, in fact, fell $322 billion between 1988 and 1991, a 35 percent decline in four years. What these numbers and the preceding events imply is that the credit crunch was a by- product of frequent changes in the rules of banking – first easing too much and then tightening. Overzealous bank examiners and reluctant bankers are themselves a product of the uncertainty caused by these changes in circumstance. Viewed in this context, the actions of many examiners and bankers would seem to be logical responses to the environment they faced. In fact, studies are beginning to show that such factors as loan delinquencies and declining returns on loan portfolios 9 explain most of the slowdown in bank lending.2 Lessons Learned What might we learn from the events of the 1980s? To begin, much of the credit crunch had its origins in unanticipated reactions by banks and thrifts to new legislation. The original intent and effect of much of this legislation could be regarded as appropriate; but, unfortunately, unintended side effects were to eventually show themselves in weak assets, loan losses, and eventually a credit crunch. What this suggests is that, in any proposed changes in our business or banking laws, we must be alert to future unintended and harmful side effects. This is important now, because in response to recent banking and thrift problems, new banking legislation is constantly being suggested. Most recently, for example, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) was enacted to replenish the bank insurance fund. But it also sets out several other primary purposes: increased supervision through timely examinations and prompt and progressive intervention at problem banks, and least cost resolution of failing institutions. The intent of these supervisory changes is to reduce insurance fund losses by quickly correcting problems at insured institutions. Major provisions include: • As capital declines, an institution will become subject to progressively harsher sanctions. These sanctions include, among others, management replacement, 2Diana Hancock and James Wilcox, "Capital Crunch or Just Another Recession," a paper presented at the 28th Annual Conference on Bank Structure and Competition, Federal Reserve Bank of Chicago, May 6-8, 1992. 10 restricted asset growth, and limits on deposit interest rates. Although many of the sanctions are similar to those now used by state and federal agencies, the agencies will have less discretion under the new framework in choosing whether to pursue a particular step. • When capital reaches two percent of assets, or a comparable level set by federal supervisory agencies, an institution will have to be placed into receivership or conservatorship within a short period of time. In other words, an institution will no longer be allowed to remain open under existing ownership until all of its capital has been exhausted. • Under the "least cost resolution" provisions for failing institutions, the FDIC will not be able to take any actions after 1994 to protect uninsured depositors if the actions would have the effect of increasing insurance fund losses. The likely result will be more bank liquidations and fewer purchase and assumption transactions; uninsured depositors will be sharing in the loss with the FDIC. Clearly, the legislation is designed to protect the bank and thrift insurance funds and the public treasury. And if FDICIA works as envisioned, it may well achieve many of the desired results. But FDICIA, as the legislation before it, has the potential to create undesirable effects as well. So we must begin asking the questions now: • Will sudden, new and tighter capital and supervisory requirements allow banks to meet credit needs as the economic recovery continues? • Will uninsured depositors leave troubled institutions before final resolution actions can be taken, thereby leaving all of the losses for the FDIC? And more importantly, 11 will these depositors leave in a manner that threatens banking stability and local or regional economic conditions? • Can the bank and thrift industries pay substantially higher deposit insurance premiums and continue to compete with other types of institutions? • Would a reduction of insurance coverage over time be a better market solution and permit less severe regulatory restrictions? These are difficult questions of course, but the lesson is that they need our attention now. They also need rational answers as we go forward and before we cause unintended results for an already damaged industry. Attention to these topics is critical now if we are to learn from the errors of the 1980s and avoid new difficulties in our financial system as we move through the 1990s.

Thomas M. Hoenig (1992, June 12). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19920613_thomas_m_hoenig

@misc{wtfs_regional_speeche_19920613_thomas_m_hoenig,
  author = {Thomas M. Hoenig},
  title = {Regional President Speech},
  year = {1992},
  month = {Jun},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19920613_thomas_m_hoenig},
  note = {Retrieved via When the Fed Speaks corpus}
}