Regional President Speech

CHALLENGES FOR BANKS IN THE 1990s Thomas M. Hoenig President Federal Reserve Bank of Kansas City Symposium XVIII for Bank Directors Santa Fe, New Mexico October 31, 1994 I am pleased to be here today and to share my views on the challenges facing bankers during the remainder of the 1990s. This role, while no easier, is at least more enjoyable than in past years, because the current banking environment is so much more positive. For many banks, in fact, the challenge no longer focuses on just survival, but, instead, on what must be done to continue current achievements. There are a number of things we can quickly point to that support this view and help set the stage for discussing the challenges banks face. First and foremost, overall bank performance remains at or near record levels. The banking industry's return on assets reached 1.23 percent in 1993 and remains nearly at that level today – an astounding turnaround from a .5 percent figure at the beginning of the 1990s. Current returns further suggest that banks are not only continuing to make progress in reducing overhead expenses and loan losses, but also are handling rising interest rates far better than many were once predicting. Another sign of the industry's resurgence is that only 12 banks have failed as of September this year with little expected loss to the FDIC. These failure numbers take us back to levels prevailing before the 1980s, when closing a bank was, indeed, rare. Moreover, this trend is quickly bringing the Bank Insurance Fund up to the desired level designated by Congress, thus raising prospects for a substantial drop in insurance premiums during 1995. Many of you may recall that, just a few years ago, several forecasters had predicted this fund would now be facing deficits of $50 billion or more. As a result of this good news, Congress has recently passed bills providing for interstate banking and limited regulatory relief. These bills do something that not many would have anticipated a few years ago – they take several notable steps toward easing the regulatory burden and making banks more efficient. 2 So, perhaps it is a good time to step back and ask ourselves what must be done to put the banking industry on the path to long-term prosperity and stability. The events of the last decade should convince us of the importance of charting such a path, while current conditions give banks the resources and flexibility to begin this process. What I would like to do then is, first, review briefly the trends that are emerging in the banking industry. Second, I will attempt to identify some of the challenges banks are facing and what might be done to ensure long-term stability. Finally, I will discuss something many bankers consider key to their survival and prosperity – what is being done to ease the regulatory burden? Emerging Trends in the Banking Industry Much of our attention over the last decade has centered on bank and thrift asset quality problems, deficits in the deposit insurance funds, and the creation of a new system of supervision. During this period, however, the banking industry itself has undergone a quite remarkable transformation in how it does business. Deregulation, rapidly increasing flows of financial information, a phenomenal rise in computer processing power, and the development of new financial theories and instruments have dramatically changed banking and most other parts of our financial system. For banks these changes mean rising competition from new sources and a transformation that mirrors many of the innovations in our financial markets. As customers are gaining direct access to markets once beyond their reach, banks are having to develop new services and financial instruments to remain competitive and help customers manage market risks. Banks are becoming 3 increasingly active in providing support and liquidity in new markets and, overall, banks' balance sheets are changing and becoming more complex. As a result, some traditional assets held by banks will play a less significant role in portfolios, while a variety of services and relatively new off balance sheet activities will become more dominant. These changes are most apparent at larger banks, but in a survey of community banks we recently conducted, we found that at least a portion of smaller banks have made or are planning a number of notable changes in their operations as well. In a sense, then, we are at a crossroads. Yes, in the recent past banks have lost a share of the financial marketplace, but new services and activities are giving innovative bankers the opportunity to maintain competitive positions and reach new customers and markets. The challenge for bankers is to take advantage of these opportunities and to do so in a sound manner. What Must Bankers Do to Ensure Long-term Prosperity and Stability? Areas where bankers will find their most significant opportunities and challenges will be in lending, managing market risks, deposit competition, banking consolidation, and fair lending. I would like to touch on each of these topics, then, for just a moment. The lending function – The first and foremost aspect in bank stability and prosperity is within the traditional credit function. Bank lending activities are changing dramatically in response to the changes in our financial markets. Some of the most creditworthy bank customers are shifting to the commercial paper market and many bank credits are being securitized and sold in the marketplace. For many of you, a substantial portion of your mortgage lending is no longer held on the balance sheet, but is being pooled and sold to institutions, funds, and individual investors. 4 Similar trends are developing in credit card and auto lending. Moreover, facilitating these trends is new banking legislation which removes some of the legal impediments to the securitization of small-business loans. Further spurring these development patterns is the fact that banks face many added costs in funding loans. These include deposit insurance premiums, nonearning reserves, capital standards, and the burden of regulation. Also, as a result of such costs, many of the credits on bank balance sheets represent lending to borrowers willing to pay a little more in interest and, therefore, possessing unique characteristics, specialized needs, and limited access to financial markets. Having said all this, I would add quickly that as banks become more specialized in the credits they hold, they need not settle for a diminished role in the credit evaluation process. Banks, in fact, will have opportunities to make credit judgments through other means. For example, many bankers will focus on originating and servicing loans to be sold or securitized, thereby avoiding the costs of holding such credits directly. Bankers will also perform credit evaluations in granting letters of credit and liquidity backups to support the commercial paper and other credit markets. While these steps will mean less lending on the balance sheet, they could place even more of a premium on good credit judgment as bankers are asked to perform a much broader role in evaluating credits. To succeed in this role and to ensure long-term prosperity, banks will need to be increasingly adept in assessing and controlling credit risks. They certainly will have to avoid many of the mistakes made during the credit boom of the 1980s – a period which saw continued declines in credit quality as loan competition intensified and marginal borrowers gained greater access to credit. In a book entitled “Money of the Mind,” James Grant documented much of this credit 5 deterioration and provided many examples of the lessons bankers and other lenders must keep in mind. Several of his examples are: • A statement by the President of CBS in 1985, “Prudence is putting debt on your balance sheet.” • The frequent calls by GMAC to federal bankruptcy courts in the 1980s. GMAC was hoping to find that its prospective credit customers were newly fledged bankrupts. Why? -- because then they wouldn't be able to file another Chapter 7 proceeding for six years and thus would be ideal candidates for five-year car loans. • A headline in the Christian Science Monitor just before the collapse of the junk bond market, “Bond funds with higher yields aren't necessarily riskier.” Another prophetic headline for some bankers in the Real Estate Times during 1988, “Lenders, Needing to Lend, Go for Broke in Soft Market.” • And for those of you who may think these times are behind us, I recently read a story about Ginger Calvert, who had just received her first credit card complete with a $10,000 credit limit. Apart from the high credit limit, there were only two things that seemed unusual. Ginger Calvert is a dog and apparently she didn't even have to beg for the card. Perhaps James Grant summed up the challenge best when he observed that “Progress is cumulative in science and engineering but cyclical in finance.” Despite these warnings, I remain quite optimistic that banks will prosper and retain a strong lending and credit evaluation role. One thing that may bode well for bankers this time around is that the memory of what poor credit standards can lead to is still very fresh in our minds. Clearly, no one 6 wants to repeat the experience of rising deposit insurance premiums, more restrictive legislation, and greater director and management liability. To address the cyclical lending patterns in which we become blinded by prosperity, there are several things that must be remembered and emphasized. First, bankers must, at the outset, establish sound lending policies and stick to them as credit competition intensifies. Many of the problem loans of the 1980s would never have been granted if bankers and others had adhered to their credit policies and standards. I am already receiving some anecdotal information that rising loan demand and competition are causing some to loosen their credit standards and ease collateral and guarantee requirements. Although lenders that adhere to sound policies may lose some lending business to those with lower standards, our past experience clearly indicates that such credits will be the first to falter. A second step toward lending success is to establish adequate loan loss reserves now while it is easier to do so. This point was brought out clearly in several studies our Bank has made of loans classified by examiners. In fact, one of the key implications of these studies is that reserves based on perceived exposure during good times will be far from adequate in dealing with the credit problems encountered in an economic downturn. Thus, if bankers are to have the flexibility to address loan problems at an early stage, they will have to begin preparing before the problems are apparent. A final step toward stable banking is to blend rapidly increasing flows of financial information with sound credit judgment. The 1980s was billed by many as the "age of information," but some of the biggest blunders in financial history were made during this period. For innovative bankers, the 1990s are providing the opportunity to better use this information in judging creditworthiness, pricing loans for risk, and providing credit services more carefully tailored to 7 customer needs. I am confident that bankers following these steps will achieve greater credit stability over the business cycle. Managing market risk and other services – Banks are setting out in new directions in managing interest rate, exchange rate, and other market risks – both for themselves and for their customers. These efforts are an outgrowth of path-breaking developments in finance and economics in such areas as asset and option pricing theories, hedging strategies, and portfolio and market efficiency theories. In addition, vast increases in computing power have opened the door for these theories to be used on a much broader and more intricate scale. Much of this expansion has centered around derivative instruments that can be used to break up and partition individual risk components, thus helping individuals, businesses, and financial institutions manage their own risk exposures. Although such activity has primarily involved larger banks, smaller banks are now using a variety of derivatives to manage their own exposures and to help important customers. As a result, derivatives and a number of off balance sheet activities promise to become an important segment of banking operations. To be successful in this area, banks must carefully manage the inherent and extremely complex risks, which is a far from easy task. In fact, a risk manager for a securities dealer was recently quoted in Fortune magazine as saying, “If I woke up one day and, God forbid, I was a regulator, I don't think I'd know what to do. With derivatives there's leverage and sometimes illiquidity, and there's complexity. Three words.” For bankers, derivatives and other risk management tools will require careful oversight from the management ranks to the staff level. The pricing and perceived risks in these instruments, for instance, are based on a number of critical assumptions that may not be clear to many participants. 8 Such assumptions may reflect underlying market conditions, previous price volatility, and historical patterns for mortgage prepayment rates and other factors – all of which may never be repeated in the same pattern if the financial environment continues to change. During the recent rise in interest rates, these points were brought home to a number of banks and many others – some of which were considered experts in this area. Consequently, management of these activities will require a banker to maintain a concerted effort to monitor the inherent risks and react quickly whenever market conditions change. To reinforce these points, the bank supervisory agencies are providing substantial training for examiners in evaluating the risks in derivatives and assessing the adequacy of management controls. I hope that bankers will continue to be aggressive in watching these activities and using them to hedge the risks rather than invite risks into their operations. Deposit competition – On the deposit and funding side, banks will continue to face strong competition from mutual funds, cash management accounts, and the rapidly expanding list of other savings and investment alternatives. One advantage banks have traditionally had is through their role in the payments system and their access to clearing and wire transfer facilities. These activities, along with extensive bank office and ATM networks, have given the banking industry a good link to customers. This advantage, though, will be strongly tested over the remainder of the 1990s as new investment alternatives are developed and as electronic innovations give customers better access to all of their funds. Bankers consequently will be under pressure not only to offer competitive returns, but to provide the type of products their customers most need. As banks' experience with mutual 9 funds demonstrates, success extends beyond just the products themselves and includes educating customers and providing competent advice. Banking consolidation – Another challenge facing banks is consolidation. The industry already has experienced much consolidation, and more seems likely with recent federal legislation allowing interstate banking and branching on a nationwide basis. As consolidation continues, I am confident that we will continue to have a variety of banking organizations operating successfully. Yes, there will be a handful of banks operating on a nationwide level. But there will also be a group of strong regional organizations, and a substantial number of community banking organizations serving both rural and metropolitan markets. onsolidation will allow larger organizations to diversify geographically and will give smaller community banks the opportunity, if needed, to combine with others to offer more diverse services or to become more efficient. However, by bringing the banking industry closer together, consolidation also seems likely to concentrate risks for the payments system, off balance sheet activities, and several other banking operations. Moreover, as with any form of change, consolidation will entail new risks and uncertainty and no assurance of success. I would note that some of the early and most feared companies making financial acquisitions – most notably CitiCorp, American Express, and Sears – did not enjoy the success they had anticipated. Also, in a study our Bank conducted, we found that interstate acquisitions varied widely in their degree of success. Thus, while consolidation can be expected to continue at a rapid pace, the most successful, as always, will be those that exercise careful judgment in selecting acquisitions and carrying out the mergers. 10 Fair lending – A final challenge to bankers is fair lending and meeting community needs – two topics which are receiving increased scrutiny from bank supervisors, the Department of Justice, and Congress. It is clear that banks must serve all segments of their marketplace if they and their communities are to prosper. Innovative and resourceful bankers, in fact, are finding many profitable ways to develop their communities and to serve low- to moderate-income groups. Bankers also are using partnerships with neighborhood groups and community lenders to identify creditworthy customers and expand their bank's lending base. In addition, many local, state, and federal programs can further add to the attractiveness of such lending. In short, successful bankers must put fair lending at the core of their operations and use it as a means of developing the full potential of their communities and ensuring the long-term stability of their banks. 11 What Can We Do to Ease the Regulatory Burden? The final subject that I want to address today concerns efforts to ease regulatory burden. In our recent survey of community banks, we found that small banks viewed the regulatory burden as the greatest threat to their survival. Moreover, when we provided an opportunity in the survey for written comments on any aspect of community banking, bankers were almost unanimous and very emotional in expressing their views on the cost of regulation. Although I've heard and responded to many of these views before, it was an extremely sobering experience to see them all within the context of our own survey -- and I am sure that many of the views are not unique to community banks alone. Consequently, I think it is very important for both bankers and regulators to stop and not only voice their concerns about regulation, but begin considering what can be done to change the framework. In this regard, the Riegle Community Development and Regulatory Improvement Act of 1994 represents a step toward easing the regulatory burden. While the provisions of this act represent moderate steps, they are noteworthy as a sign of change in Congressional concerns from just a few years ago. Among the specific relief provisions are: expansion in the number of small banks eligible for the longer 18-month exam cycle, coordinated exams for banking organizations, reduction in currency transaction report filings, call report simplification, and the easing of some application requirements and several standards in FDICIA. This legislation also calls for studies on such topics as the payment of interest on reserves and the effect of risk-based capital standards on the economy. Finally, the act sanctions further attempts by federal supervisors to simplify the regulatory system. 12 Apart from this legislation, a number of other steps also have been taken or soon will occur. These include lowering reserve requirements in 1992, changing appraisal standards, and future decreases in deposit insurance premiums. In addition, the efforts to revise CRA regulations, while far from perfect, may ease the compliance burden for a substantial number of small banks. An additional contribution to easing the regulatory burden may come from recent changes in supervision. Banking supervision is placing renewed emphasis on a bank's policies, controls, and management involvement. As a result, more focus will be given to a bank's success in monitoring and controlling overall risk exposure, and to the extent this exposure is managed well, less attention may be given to some of the more burdensome details of regulation. In addition, soundly operated banks with proven performance records are likely to be the first to be accorded greater regulatory flexibility and broader powers. Several examples of this already exist in which well-capitalized banks face fewer regulatory restrictions than other banks. Bankers and regulators also are considering other reforms that might help keep deposit insurance premiums low or pave the way for broader activities in banking. While different segments of the banking system are far from unanimous in supporting these reforms, they certainly need to be considered. Among such proposals are tighter limits on deposit insurance coverage, greater separation between the banking and nonbanking activities conducted by banking organizations, use of core or narrow banks across part of the banking industry, and other cutbacks in the federal safety net. Such proposals, if feasible, might provide an opportunity to reduce the overall level of regulation in banking. 13 All of these steps suggest that further easing of the regulatory burden is possible. Not too surprisingly, much of the responsibility will rest with the banking industry, and, of course, regulatory relief will be contingent on our success in maintaining a healthy banking industry. Conclusion Overall, the banking industry has come a long way since the problems of the late 1980s surfaced. I am cautiously optimistic that we will take advantage of current banking prosperity and strive to maintain our recent gains while preparing for changing circumstances and new challenges. Banks clearly face many challenges in coping with rapid change and operating in a very competitive environment. The banking industry, though, has a unique opportunity now to chart a course for long-term prosperity and stability. This course will require bankers to adhere to sound policies and yet be innovative in serving their customers and communities. Moreover, success in this manner may further lead to a declining regulatory burden and new opportunities to compete in the financial marketplace.

Thomas M. Hoenig (1994, October 30). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19941031_thomas_m_hoenig

@misc{wtfs_regional_speeche_19941031_thomas_m_hoenig,
  author = {Thomas M. Hoenig},
  title = {Regional President Speech},
  year = {1994},
  month = {Oct},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19941031_thomas_m_hoenig},
  note = {Retrieved via When the Fed Speaks corpus}
}