[Senate Hearing 107-504]
[From the U.S. Government Publishing Office]
S. Hrg. 107-504
THE CONDITION OF THE
U.S. BANKING SYSTEM
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED SEVENTH CONGRESS
FIRST SESSION
ON
THE EXAMINATION OF ISSUES RELATED TO THE CONDITION OF THE UNITED STATES
BANKING SYSTEM, INCLUDING THE EFFECTS OF THE SUGGESTED DETERIORATING
BANK ASSET QUALITY, AND IMPROVED RISK MANAGEMENT AND CONTROL SYSTEMS
NEEDED TO RESPOND TO CHANGING ECONOMIC EVENTS
__________
JUNE 20, 2001
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
80-302 U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 2002
____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpr.gov Phone: toll free (866) 512-1800; (202) 512�091800
Fax: (202) 512�092250 Mail: Stop SSOP, Washington, DC 20402�090001
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
PAUL S. SARBANES, Maryland, Chairman
CHRISTOPHER J. DODD, Connecticut PHIL GRAMM, Texas
JOHN F. KERRY, Massachusetts RICHARD C. SHELBY, Alabama
TIM JOHNSON, South Dakota ROBERT F. BENNETT, Utah
JACK REED, Rhode Island WAYNE ALLARD, Colorado
CHARLES E. SCHUMER, New York MICHAEL B. ENZI, Wyoming
EVAN BAYH, Indiana CHUCK HAGEL, Nebraska
JOHN EDWARDS, North Carolina RICK SANTORUM, Pennsylvania
ZELL MILLER, Georgia JIM BUNNING, Kentucky
MIKE CRAPO, Idaho
DON NICKLES, Oklahoma
Steven B. Harris, Staff Director and Chief Counsel
Wayne A. Abernathy, Republican Staff Director
Martin J. Gruenberg, Senior Counsel
Aaron Klein, Economist
Sarah Dumont, Republican Professional Staff Member
Linda L. Lord, Republican Chief Counsel
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
George E. Whittle, Editor
(ii)
C O N T E N T S
----------
WEDNESDAY, JUNE 20, 2001
Page
Opening statement of Chairman Sarbanes........................... 1
Prepared statement........................................... 46
Opening statements, comments, or prepared statements of:
Senator Gramm................................................ 2
Senator Johnson.............................................. 3
Senator Shelby............................................... 4
Senator Reed................................................. 4
Senator Allard............................................... 5
Senator Corzine.............................................. 5
Senator Bunning.............................................. 5
Senator Dodd................................................. 6
Senator Bayh................................................. 17
Senator Schumer.............................................. 36
Senator Carper............................................... 39
WITNESS
Alan Greenspan, Chairman, Board of Governors of the Federal
Reserve System, Washington, DC................................. 7
Prepared statement........................................... 46
Response to written questions of Senator Sarbanes............ 79
Response to written questions of Senator Ensign.............. 92
John D. Hawke, Jr., Comptroller of the Currency, U.S. Department
of the Treasury, Washington, DC................................ 10
Prepared statement........................................... 54
Response to written questions of Senator Sarbanes............ 94
Donna Tanoue, Chair, Federal Deposit Insurance Corporation,
Washington, DC................................................. 12
Prepared statement........................................... 64
Response to written questions of Senator Sarbanes............ 105
Ellen Seidman, Director, Office of Thrift Supervision, U.S.
Department of the Treasury, Washington, DC..................... 14
Prepared statement........................................... 70
Response to written questions of Senator Sarbanes............ 119
(iii)
THE CONDITION OF THE
U.S. BANKING SYSTEM
----------
WEDNESDAY, JUNE 20, 2001
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:05 a.m., in room SD-538 of the
Dirksen Senate Office Building, Senator Paul S. Sarbanes
(Chairman of the Committee) presiding.
OPENING STATEMENT OF CHAIRMAN PAUL S. SARBANES
Chairman Sarbanes. The Committee will come to order. I am
very pleased to welcome this distinguished panel of witnesses
before the Banking, Housing, and Urban Affairs Committee this
morning: Alan Greenspan, the Chairman of the Federal Reserve
Board; Jerry Hawke, the Comptroller of the Currency; Donna
Tanoue, the Chair of the Federal Deposit Insurance Corporation;
and Ellen Seidman, the Director of the Office of Thrift
Supervision.
The purpose of today's hearing is to review the condition
of the banking system of the United States. The witnesses have
been asked to testify regarding the safety and soundness of the
banking industry and its impact on the economy, as well as any
potential problems they foresee facing the financial services
industry.
It has always been a charge of this Committee to concern
itself with the safety and soundness of the financial system,
which is, after all, fundamental to the effective functioning
of our economy. In fact, the safety and soundness of the
American financial system has been one of the strengths of our
economic system in comparison with many other countries around
the world.
This hearing is not prompted by any triggering event or
problem. Rather, it is our intention to have a practice of
holding periodic oversight hearings on the state of the banking
system. By making this a regular event, we would hope to
elevate scrutiny of the system when times appear to be good and
there may be a tendency toward complacency, as well as to
diffuse potential alarm when a hearing is held at a time when
problems may exist. We would hope that such periodic hearings
would be a useful discipline on the system and perhaps serve as
a stabilizing influence.
It appears that the past decade of economic growth has
significantly strengthened the condition of the U.S. banking
system. It is my own view that enactment by Congress of the
Financial Institutions Reform, Recovery, and Enforcement Act,
FIRREA, of 1989, in response to the thrift crisis, and the
Federal Deposit Insurance Corporation Improvement Act (FDICIA),
of 1991, in response to the commercial banking problems of the
late 1980's and early 1990's, made a contribution to that
improved condition. The capital and regulatory standards put in
place by those statutes helped the system to take advantage of
the growing economy of the 1990's. The improved coordination of
supervision by the regulators has made a substantial
contribution and we are encouraged to see the increased
coordination that is taking place amongst the regulators. We
think that is a very positive development.
This morning, we will hear from the regulators that the
banking industry is better situated today to withstand the
softening of the economy than it has been in the past. Banks
have a greater variety of products and more geographical
diversification in their assets. They have higher earnings,
more capital, better risk-management techniques, and higher
asset quality than in the past. Nevertheless, problems do exist
and there are some trend lines that I think are of some
concern.
Asset quality has degraded over the past 2 years and loan
loss provisions have increased substantially. Noninterest
income of banks has been affected. And net interest margins
have declined. The manufacturing sector has also been slowing
down, which affects commercial loan quality. Mounting employee
layoffs adversely affecting consumer loan quality. And
consumers are more highly leveraged today than any other
measured point.
The Committee will want to review all of these issues with
the regulators this morning. Mainly, we want to get an
assessment not only of how the system looks today, but also how
it may look 6 months or a year from now. The consensus forecast
is that economic growth will pick up in the third and fourth
quarters of this year and resume at a faster pace next year. If
this happens, one can assume it will have a beneficial impact
on the banking system.
But we need to have some sense of how well equipped the
system is to cope with a weak economy, as well as a growing
economy. And we want the regulators to lay out for us not only
how they see the landscape, but also any recommendations they
have which would help to improve or ensure the safety and
soundness of the financial system. So, I want to welcome our
four distinguished witnesses.
I yield to the Ranking Member, Senator Gramm.
COMMENTS OF SENATOR PHIL GRAMM
Senator Gramm. Well, Mr. Chairman, first, let me thank you
for this hearing. I cannot think of a more important issue for
the Committee to concern itself with than oversight of the
greatest banking and financial system in the history of the
world.
We have gone through a slowdown and readjustment and, to
some degree, to quote a famous oracle: ``Seen the end of,
irrational exuberance, in the equity market. Anything
irrational ultimately has to come to an end.''
I hope and believe that the American economy is still
fundamentally sound. If the consensus projections are right,
many of these indicators should be improving even as we have
this meeting, but oversight is always a good thing.
I want to congratulate you, Mr. Chairman, on your
leadership in this area. I want to thank our regulators,
especially those who are leaving at the end of a tenure which I
believe they can be proud of. I look forward to hearing, them
and from having an opportunity to ask questions. Thank you.
Chairman Sarbanes. Very good. Thank you.
Senator Johnson.
STATEMENT OF SENATOR TIM JOHNSON
Senator Johnson. Thank you, Mr. Chairman. I cannot think of
a more appropriate hearing than to have this hearing today,
taking a look at the four bank and thrift regulatory agencies
under our jurisdiction on the condition of the U.S. banking
system, as your first hearing as Chairman of the Banking
Committee during this 107th Congress.
I want to thank the panel members for joining us today and
Senator Gramm for his excellent leadership during the unusual
course of events that have occurred the past year during this
Congress.
Clearly, the banking industry is in overall excellent
condition at this time. They have earned a record $19.9 billion
during the first quarter, exceeding the previous record set in
2000. This year marks the eighth consecutive year in which
banks earned a return on investment in excess of 1 percent.
Prior to 1993, the industry never had an ROA in excess of 1
percent. So these have been remarkable times in many ways.
Nonetheless, there are points of concern during a time of
economic slowdown where asset quality problems have worsened
over the past 2 years and loan loss provisions have increased,
margins have come down, in part because of more competition
from a wide variety of bank and nonbank lenders. Loan losses
have continued to rise and bank deposits have not increased as
quickly as bank loans. I believe that the condition of the
banking industry is indeed solid, in large measure due to the
regulatory oversight of the individuals before the Committee
today.
As the new Chairman of the Financial Institutions
Subcommittee, I have a particular interest in the deposit
insurance system. And I applaud Ms. Tanoue on her leadership at
the FDIC and all that she has done there. I have appreciated
their recommendations on FDIC's reform. It is difficult to
argue with the FDIC's observation that the current system is in
fact pro-cyclical. That is, in good times, most institutions
pay nothing for insurance coverage. And in bad times, when they
can least afford it, institutions potentially can be hit with
huge premiums. At the same time, insured deposit limits have
not kept pace with inflation. I am also concerned about
significant inflows of insured deposits into the system and the
impact that this has had on deposit reserves.
These are difficult issues. And I look forward to working
with the regulators, industry groups, and consumers to develop
a sensible, fair reform approach. I have had an opportunity now
to engage in some discussion with Chairman Sarbanes and I look
forward to the possibility of holding hearings in the Financial
Institutions Subcommittee on the FDIC's reform proposal. We
should be able to have a comprehensive deposit insurance bill
put together in a bipartisan consensus fashion, hopefully after
the July 4 recess.
So, again, Mr. Chairman, thank you for holding this hearing
and I look forward to working with you and with Ranking Member
Gramm closely on our agenda over the remainder of this year.
Chairman Sarbanes. Thank you very much, Senator Johnson.
Senator Shelby.
COMMENTS OF SENATOR RICHARD C. SHELBY
Senator Shelby. Thank you, Mr. Chairman.
I want to thank you for calling this hearing. It is very
important for this Committee to be holding a hearing on the
condition of the banking system.
The banking system plays a crucial role in the development
of the American economy. While I believe the market--the
initiative and efforts of individuals and firms--provides the
fundamental driving force behind the success and the strength
of the American financial system, I recognize that we have
adopted some regulatory safeguards from such market forces.
These measures are intended to temper instability in the
banking system that could have devastating effects on the
overall economy.
This hearing, Mr. Chairman, provides us with an excellent
opportunity to consider the performance of the regulatory
framework that we have put in place. It is my hope that the
Committee adopts a balanced approach today and closely
considers both regulations that protect the integrity of the
system, as well as those which are ineffective, overly
burdensome, and weaken banking institutions.
I look forward to the testimony from today's witnesses and
I commend you for calling the hearing, Mr. Chairman.
Chairman Sarbanes. Thank you very much.
Senator Reed.
COMMENTS OF SENATOR JACK REED
Senator Reed. Thank you very much, Mr. Chairman. Again, let
me commend you and the Ranking Member for holding this hearing
today. I think it is important to get an oversight of the
status and the health of the banking system. And from your
comments and my colleagues' comments, the system is generally
healthy.
But it is a system that has been changing dramatically over
the last several years--significant consolidations, blurring of
lines between traditional financial institutions. This is a
very appropriate time to make an assessment of the status, the
health, and the future of the banking system.
It also gives us an opportunity to put in context specific
issues that we will deal with as we go forward--continuation of
discussions about financial privacy that began under the
auspices of the Gramm-Leach-Bliley debate. As Senator Johnson
indicated, discussions of comprehensive deposit insurance
reform.
In addition, it will give us an opportunity to probe some
of the comments that I hear back in Rhode Island that
businesses find it harder to get credit, certainly small
businesses, not in the context of the credit crunch of about a
decade ago, but just simply the difficulty of working with
these larger institutions. This is an important opportunity to
examine the financial services industry and I thank you for
your foresight in calling the hearing, Mr. Chairman.
Chairman Sarbanes. Thank you very much, Senator Reed.
Senator Allard.
COMMENTS OF SENATOR WAYNE ALLARD
Senator Allard. Mr. Chairman, I just want you to know that
I think it is good that you are moving forward here with an
oversight hearing on the condition of the banking system. As
the previous Chairman and now Ranking Member of the Housing
Subcommittee, I personally focused on safety and soundness of
housing programs such as FHA and the government-sponsored
enterprises. Obviously, I am enthusiastic to see us focus on
the safety and soundness of the banking system.
I am a big believer in oversight. Each Congressional
committee should take seriously its oversight responsibilities
for the agencies under its jurisdiction. I look forward to
hearing from each of the principal regulators of our banking
systems.
I would just second the comments of my colleague from
Texas, Senator Gramm, that we have the greatest banking system
in the world. And I believe that America is better for it.
Thank you.
Chairman Sarbanes. Thank you, Senator Allard.
Senator Corzine.
COMMENTS OF SENATOR JON S. CORZINE
Senator Corzine. Thank you, Mr. Chairman, and Ranking
Member. I congratulate you both for very positive leadership in
the whole process of dealing with the regulatory oversight
function and the advancements that I think have occurred in the
financial system in the last decade, including the recent
legislation modernizing financial markets.
I also want to congratulate and welcome the regulators. I
think that they have done an outstanding job in actually
treading through waters that, in retrospect, look a lot calmer
than they probably felt when you went through them. There were
a number of shocks and dislocations that were more difficult to
manage than I think may appear the case today.
Finally, I would just like to say that I think the balance
that is struck between the private sector's participation,
obvious participation, and the effectiveness of our regulatory
structures has been a fundamental underpinning of that great
sound banking system that is an important part of our economy
and the growth of our economy through the years. This is one of
those places where I think we have the balance just about
right.
Chairman Sarbanes. Senator Bunning.
COMMENTS OF SENATOR JIM BUNNING
Senator Bunning. Thank you, Mr. Chairman. I believe it is a
very good idea to have the regulators periodically come before
the Congress. Chairman Greenspan often comes up here and we can
ask him questions about monetary policy, as well as the banking
system questions.
Mr. Chairman, I would like to thank all of our witnesses
for testifying today and I would like to thank you for holding
this important hearing. But the other regulatory agencies do
not get a chance to visit us as often. I believe it is
important that we communicate. Sometimes we feel that
regulations written do not accurately reflect our legislative
efforts. I hope we can do a better job of communicating our
intentions as you continue to advise us.
I do not think there is any debate that the safety and
soundness of our banking system is of paramount importance. The
system is working well, but we must remain vigilant to ensure
its continued success. That success is critical, not only to
ensure our Nation's financial stability, but also given the
importance that our system holds in the financial world
markets, it is even that more critical.
I thank you all for coming here today and I look forward to
your testimony.
Thank you, Mr. Chairman.
Chairman Sarbanes. Thank you, Senator Bunning.
Senator Dodd.
STATEMENT OF SENATOR CHRISTOPHER J. DODD
Senator Dodd. Thank you, Mr. Chairman. And let me thank our
witnesses once again for appearing before us. We always enjoy
hearing from them. They offer very valuable and worthwhile
testimony. I thank you for being here.
I want to thank you, Mr. Chairman, for hosting today's
hearing also with my other colleagues. I thank Phil Gramm for
his leadership during his tenure on the Committee and look
forward to Chairman Sarbanes' leadership of this Committee. I
have had the privilege and pleasure of serving with you for
some 20 years. I am delighted to call you Chairman of this
Committee now after watching your wonderful work over the
years.
I want to thank Donna Tanoue. A couple of years ago, Mr.
Chairman, Donna came to Hartford, Connecticut and took a whole
day to get there. It was terrible weather. In terms of just
reassuring the folks up there, keeping that office functioning,
as she made tremendous efforts to ensure the safety and
soundness of our financial institutions. I am very grateful to
you for the work you did during those years and for your visit
to Hartford.
Mr. Chairman, yesterday we had a hearing in this very room,
and some of my colleagues were here. I know Jon Corzine was and
I think you were, Mr. Chairman, as well as John Robson, the new
head of the Export-Import Bank, and Secretary Taylor of the
Treasury. John Robson made a case that the risk levels, the
risk profiles, for lending had improved significantly. That was
the argument, and a number of our colleagues as a result of
that, the budgetary request from the Administration was reduced
for the Export-Import Bank by 25 percent, arguing that because
risk assessments have improved, that we may not need as much
budgetary authority to support lending. Some of us on the
Committee found that a bit incongruous in light of some of the
recent reports out of Asia and Latin America regarding
instability, to put it mildly.
Based on the testimony that has been submitted, we will be
hearing how our Nation's banking system, thrifts and financial
holding companies, seem to be flourishing. I am not arguing
with that testimony, and I have such high regard for all four
of our witnesses, I do not question that at all. However, I
remain a bit concerned. I hope I can hear this either in the
testimony or in some of your question and answer period, what
the potential impact that global financial downturns could have
on our domestic financial institutions.
I have listened to all of you at various times talk about
the global economy and how we no longer can live in an isolated
world where events in Asia, and Latin America do not impact our
own financial institutions. In light of yesterday's testimony
and today's, I hope we might get a chance to touch on that. And
again, I thank all four of you for your fine work.
Thank you, Mr. Chairman.
Chairman Sarbanes. Well, thank you very much.
We will now turn to the panel. Let me just say that you
have all submitted to the Committee some very thoughtful
statements and we are deeply appreciative of that. I think if
we could hold it to about 10 minutes each in your presentation.
I know a lot of work has gone in and we want to try to hear you
out. On the other hand, we have limited time and Members want
to ask their questions. If you can keep it under 10 minutes,
the more the better, but I leave that to you. And then we will
go to a question period.
Now, Ms. Seidman, I know you had a previous engagement and
have to leave, I think, at about noon, and we understand that
when the time comes. Chairman Greenspan, why don't we start
with you and then we will move straight across the panel to Mr.
Hawke, Chairman Tanoue, and Ms. Seidman.
STATEMENT OF ALAN GREENSPAN
CHAIRMAN, BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Chairman Greenspan. Thank you, Mr. Chairman.
It is the first time I have appeared before you as Chairman
in a long, long time.
Senator Bunning. Mr. Greenspan, can you pull the mike up so
that we can all hear you?
Chairman Greenspan. Is that better? Good.
Mr. Chairman and Members of the Committee, I am pleased to
be here this morning to discuss the condition of the U.S.
banking system. In my presentation today, I would like to raise
just a few issues. I have attached an appendix in which the
Federal Reserve Board staff provides far more detail relevant
to the purpose of these hearings.
There are, I believe, two salient points to be made about
the current state of the banking system. First, many of the
traditional quantitative and qualitative indicators suggest
that bank asset quality is deteriorating and that supervisors
therefore need to be more sensitive to problems at individual
banks, both currently and in the months ahead. Some of the
credits that were made in earlier periods of optimism--
especially syndicated loans--are now under pressure and
examination. The softening economy and/or special circumstances
have particularly affected borrowers in the retail,
manufacturing, health care, and telecommunications industries.
California utilities, as you know, have also been under
particular pressure. All of these, and no doubt other problem
areas that are not now foreseeable, require that both bank
management and supervisors remain particularly alert to
developments.
Second, we are fortunate that our banking system entered
this period of weak economic performance in a strong position.
After rebuilding capital and liquidity in the early 1990's,
followed by several years of post-World War II record profits
and very strong loan growth, our banks now have prudent capital
and reserve positions. In addition, asset quality was quite
good by historical standards before the deterioration began.
Moreover, in the last decade, as I will discuss more fully in a
moment, banks have improved their risk-management and control
systems, which we believe may have both strengthened the
resultant asset quality and shortened banks' response time to
changing economic events. This potential for an improved
reaction to cyclical weakness, and better risk-management, is
being tested by the events of recent quarters and may well be
tested further in coming quarters.
We can generalize from these recent events to understand a
bit better some relevant patterns in banking, patterns that
appear to be changing for the better. The recent weakening in
loan quality bears some characteristics typical of traditional
relationships of loans to the business cycle--the
procyclicality of bank lending practices. The rapid increase in
loans, though typical of a normal expansion of the economy, was
unusual in that it was associated with more than a decade of
uninterrupted economic growth.
As our economy expanded, business and household financing
needs increased and projections of future outcomes turned
increasingly optimistic. In such a context, the loan officers
whose experience counsels that the vast majority of bad loans
are made in the latter stages of a business expansion, have had
the choice of: One, restraining lending, and presumably losing
market share; or two, hoping for repayment of new loans before
conditions turn adverse. Given the limited ability to foresee
turning points, the competitive pressures led, as has usually
been the case, to a deterioration of underlying loan quality as
the peak in the economy approached.
Supervisors have had comparable problems. In a rising
economy buffeted by competitive banking markets, it is
difficult to evaluate the embedded risks in new loans or to be
sure that adequate
capital is being held. Even if correctly diagnosed, making that
supervisory case to bank management can be difficult because,
regrettably, incentives for loan officers and managers
traditionally have rewarded loan growth, market share, and the
profits that derive from booking interest income with, in
retrospect, inadequate provisions for possible default.
Moreover, credit-risk specialists at banks historically have
had difficulty making their case about risk because of their
inability to measure and quantify it. At the same time, with
debt service current and market risk premiums cyclically low,
coupled with the same inability to quantify and measure risk,
supervisory criticisms of standards traditionally have been
difficult to justify.
When the economy begins to slow and the quality of some
booked loans deteriorates, as in the current cycle, loan
standards belatedly tighten. New loan applications that earlier
would have been judged creditworthy, especially since the
applications are now being based on a more cautious economic
outlook, are nonetheless rejected, when in retrospect it will
doubtless be those loans that would have been the most
profitable to the bank.
Such policies are demonstrably not in the best interests of
banks' shareholders or the economy. They lead to an unnecessary
degree of cyclical volatility in earnings and, as such, to a
reduced long-term capitalized value of the bank. More
importantly, such policies contribute to increased economic
instability.
The last few years have had some of the traditional
characteristics I have just described: the substantial easing
of terms as the economy improved, the rapid expansion of the
loan book, the deterioration of loan quality as the economy
slowed, and the cumulative tightening of loan standards.
But this interval has had some interesting characteristics
not observed in earlier expansions. First, in the mid-1990's,
examiners began to focus on banks' risk-management systems and
processes; at the same time, supervisors' observations about
softening loan standards came both unusually early in the
expansion and were taken more seriously than had often been the
case. The turmoil in financial markets in 1998, associated with
both the East Asian crisis and the Russian default, also
focused bankers' attention on loan quality during the continued
expansion in this country. And there was a further induced
tightening of standards last year in response to early
indications of deteriorating loan quality, months before
aggregate growth slowed.
All of this might have been the result of idiosyncratic
events from which generalizations should not be made. Perhaps.
But at the same time another, more profound development of
critical importance had begun: the creation at the larger, more
sophisticated banks of an operational loan process with a more
or less formal procedure for recognizing, pricing, and managing
risk. In these emerging systems, loans are classified by risk,
internal profit centers are charged for equity allocations by
risk category, and risk adjustments are explicitly made.
In short, the formal measurement and quantification of risk
has begun to occur and to be integrated into the loan-making
process. This is a sea change--or at least the beginning of
one. Formal risk-management systems are designed to reduce the
potential for the unintended acceptance of risk and hence
should reduce the procyclical behavior that has characterized
banking history. But, again, the process has just begun.
The Federal banking agencies are trying to generalize and
institutionalize this process in the current efforts to reform
the Basel Capital Accord. When operational, near the middle of
this decade, the revised accord, Basel II, promises to promote
not only better risk-management over a wider group of banks but
also less-intrusive supervision once the risk-management system
is validated. It also promises less variability in loan
policies over the cycle because of both bank and supervisory
focus on formal techniques for managing risk.
In recent years, we have incorporated innovative ideas and
accommodated significant change in banking and supervision.
Institutions have more ways than ever to compete in providing
financial services. Financial innovation has improved the
measurement and the management of risk and holds substantial
promise for much greater gains ahead.
Building on bank practice, we are in the process of
improving both lending and supervisory policies that we trust
will foster better risk-management; but these policies could
also reduce the procyclical pattern of easing and tightening of
bank lending and accordingly increase bank shareholder values
and economic stability. It is not an easy road, Mr. Chairman,
but it seems that we are well along it.
Thank you.
Chairman Sarbanes. Very good. Thank you very much, Mr.
Chairman. You are right on the money on the time, too. We
appreciate that very much.
[Laughter.]
Mr. Hawke, we would be happy to hear from you.
STATEMENT OF JOHN D. HAWKE, JR.
COMPTROLLER OF THE CURRENCY
U.S. DEPARTMENT OF THE TREASURY
Mr. Hawke. Thank you, Mr. Chairman, Senator Gramm, Members
of the Committee. I appreciate this opportunity to discuss the
condition of the banking system and welcome this hearing by the
Committee.
If one were to take a snapshot of our banks today, it would
show a system that evidences great strength. Capital and
earnings are at very high levels by historical measure. Yet, if
one were to look at a moving picture of the system spanning the
past few years, it would disclose trends that cause concern.
Let me elaborate.
The last decade has been a period of economic prosperity
and strong growth in the banking sector. Commercial bank credit
grew by over 5 percent per year during the 1990's. During this
period of prosperity, most banks strengthened their financial
positions and improved their risk-management practices.
As a result, the national banking system is in a much
better position to bear the stresses of any economic slowdown.
National banks are reporting strong earnings with a return on
equity (ROE) for the first quarter of this year of 15.2
percent--a level considerably higher than the ROE of 11.5
percent prior to the last economic slowdown in 1990-1991.
Fifty-five percent of banks reported earnings gains from a year
ago. Asset quality for the national banking system is better.
The ratio of noncurrent loans--that is, loans that are 90-plus
days past due and in a nonaccrual status--to total loans is 1.3
percent, compared to 3.3 percent in the first quarter of 1990,
the year marking the start of the last slowdown. And capital
levels are at historical highs. As of the first quarter of
2001, the ratio of equity capital to assets was 8.9 percent,
compared to 6.0 percent in the first quarter of 1990.
Greater diversification of income sources improved the
quality of bank earnings during the 1990's. This
diversification trend should improve the capacity of banks to
weather difficult economic times and better manage the risks
embedded in their operations. The trend away from reliance on
traditional interest income is in part an active effort by
banks to better manage risk. As a supervisor, we strongly
support the efforts of national banks to diversify their
revenue streams through financially related activities.
Banks have also made gains during these years in
diversifying risks. Loan securitization has become a
significant funding tool. Banks have broadened the geographic
scope of their operations and increased the range of financial
services they offer, providing them with a greater capacity to
weather adverse economic developments. Advances in information
technology along with more sophisticated risk measurement tools
now provide bank managers with advanced risk-management tools
that were unavailable a decade ago.
There are, however, trends that concern us, and banks
cannot afford to be complacent about the risks that will
continue to surface in the current economic environment,
particularly in the areas of credit and liquidity.
While the level of loan losses is still relatively low,
since 1997 the OCC has been concerned about a lowering of
underwriting standards at many banks. This relaxation of
standards stems from the competitive pressure to maintain
earnings in the face of greater competition for high-quality
credits, particularly from nonbank lenders. In some cases,
banks' credit risk-management practices did not keep pace with
changes in standards. We now are beginning to see the
consequences of those market and operational strategies in a
rising number of problem loans.
One area where this is most noticeable is in our annual
review of Shared National Credits. In 1999 and 2000, adversely
rated Shared National Credits increased 53 percent and 44
percent, respectively. In addition, the severity of
classifications increased in both years. While this year's
Shared National Credit review is not yet complete, we expect
problem credits will rise further, reflecting the effects of
prior lending excesses, a slowing economy, and improved risk
recognition by bankers themselves.
And this emerging deterioration of credit quality is not
just an issue for large banks. As corporate earnings have
weakened, the spill-over effects on credit portfolios are
beginning to show up in the smaller institutions.
Funding risk at banks is also increasing as households and
small businesses reduce their holdings of commercial bank
deposits. Banks have traditionally relied on consumers and
small businesses in their communities as a major source of
funding. With the rapid run-up in the stock market in the
1990's, however, and the widespread popularity of money market
mutual funds, households and small businesses have increasingly
shifted their savings and transaction accounts into pension
funds, equities, and mutual funds.
Our job as bank supervisors is to maintain a sound banking
system by encouraging banks to address problems early so that
they can better weather economic downturns and are in a
position to contribute effectively to economic recovery.
By acting early, in a measured and calibrated way, bank
supervisors can moderate the severity of problems in the
banking system that will inevitably arise when the economy
weakens. By responding when we first detect weak banking
practices, supervisors can avoid the need to take more
stringent actions during times of economic weakness. We make
our greatest contribution to a sound economy by working to
preserve the ability of our banks to make creditworthy loans
when the demand exists.
Since 1997 the OCC has implemented a series of increasingly
firm regulatory responses to rising credit risks and weak
lending and risk-management practices. These efforts, which are
highlighted in my prepared statement, have focused on
maintaining an open and candid dialog with the banking industry
and our examiners about rising risk in the system and the need
for improved risk-management by bankers.
National banks have responded positively to these
initiatives. Bankers are adjusting both their risk selection
and underwriting practices. Credit spreads are wider, recent
credit transactions are better underwritten than they were as
little as 12 months ago, and speculative grade and highly
leveraged financing activity has slowed in both the bank and
public credit markets. The OCC has also taken a number of
steps, particularly examiner training and banker education, to
address our concerns about increasing liquidity and funding
risk.
We recognize that we need to ensure a balanced approach as
economic conditions weaken. We have implemented, and will
continue to follow, a careful but firm approach to addressing
weak practices and increasing risks. In this regard, we are
constantly mindful that the alternative approach of silent
forbearance can allow problems to fester and deepen to the
point where sound remedial action is no longer possible--a
lesson that all bank supervisors learned painfully in the late
1980's and early 1990's.
If we learned anything from past economic crises both in
the United States and overseas, we know that a sound banking
system is essential to continued economic growth. I can assure
you that the OCC will remain vigilant in our efforts to
continually improve the risk-management of national banks and
thereby contribute to a viable, healthy industry to support our
economy.
Thank you, Mr. Chairman.
Chairman Sarbanes. Well, thank you very much, Mr. Hawke.
Ms. Tanoue, let me say that I know that you have announced
you will be stepping down I think on July 11 or 12. I want to
join with the comments that were made by Senator Dodd and other
expressions that you have received in thanking you very much
for your distinguished service and your leadership at the FDIC
over these now somewhat more than 3 years. We really appreciate
the contributions that you have made. You have done real public
service and we are all very grateful to you for it. We would be
happy to hear your statement.
STATEMENT OF DONNA TANOUE, CHAIR
FEDERAL DEPOSIT INSURANCE CORPORATION
Ms. Tanoue. Thank you very much.
Mr. Chairman, and Members of the Committee, thank you for
the opportunity to testify on behalf of the Federal Deposit
Insurance Corporation (FDIC) regarding the condition of the
bank and thrift industries and the deposit insurance funds.
I am pleased to join with my colleagues here today to
report that the banking and thrift industries continue to
exhibit strong financial results. The two insurance funds
reflect the favorable condition of the industry as well.
The most important message that I wish to leave with you
today is that there are flaws in our deposit insurance system
and they warrant your attention. The best time for constructive
debate on changes to the deposit insurance system is now,
during a period of financial health for the industry, rather
than in the charged atmosphere of a crisis. Even in these good
economic times, the Bank Insurance Fund has not been keeping
pace with insured deposits. Consider this--the Bank Insurance
Fund, or BIF, reserve ratio stood at 1.39 percent at year-end
1997. A combination of factors pushed it down to 1.35 percent
by year-end 2000. And very rapid deposit growth has pushed the
BIF reserve ratio even further down another three basis points,
to 1.32 percent at the end of the first quarter of this year.
The Savings Association Insurance Fund, or SAIF, has been more
stable and stood at 1.43 percent of insured deposits at the end
of the first quarter, the same as year-end 2000.
But we shouldn't assume that the current good times for the
industry will last forever. We are already seeing signs of
stress that indicate that continued strong industry performance
will be much more difficult to achieve in the future. The signs
of stress include shrinking net interest margins, increasing
numbers of problem loans, and concentrations of higher risk
loans as a percentage of capital. In addition, as highlighted
in our testimony, the FDIC is keeping a close watch on certain
subprime lending activities, developments in the agricultural
sector, and the efforts of banks to address their funding
needs. While all of these signs of stress are real, I do not
want to overstate them. Depository institutions remain in a
position of strength. And we should take advantage of this
strength to reform the deposit insurance system now, instead of
waiting until the industry weakens and the flaws in the system
become more evident.
Our deposit insurance system has 2 primary flaws. First, 92
percent of the insured institutions in our country pay no
premium for coverage--rendering the risk-based premium system
ineffective, reducing the incentive for banks to avoid risks,
providing incentives for rapid growth, and forcing safer
institutions to subsidize riskier ones. Second, our current
system could also have a harmful economic side effect, a
procyclical bias, a tendency to make an economic downturn
longer and deeper than it might otherwise be.
During a severe downturn, the current statutory framework
would require that the FDIC charge banks high premiums, perhaps
as high as 23 basis points, limiting the availability of credit
to communities when they need it most and impeding economic
recovery.
The FDIC essentially has put forward 5 recommendations, and
I would like to go over them very briefly.
Recommendation one--the FDIC should be given the authority
to charge all institutions premiums on the basis of risk,
independent of the level of the deposit insurance fund. The
FDIC, like other insurers, should price its product to reflect
its risk of loss.
Recommendation two--the laws should be changed to eliminate
sharp premium swings. If the fund falls below a target level,
the law should allow premiums to increase gradually. Charging
premiums more evenly over time, allowing the insurance fund to
absorb some losses temporarily, and increasing premiums more
gradually than is required at present would soften the blow of
an economic downturn.
Recommendation three--the FDIC should be given the
authority to rebate portions of deposit insurance premiums
based on past contributions to the fund, when the deposit
insurance fund is above a specified target level. Tying rebates
to the current assessment base would increase moral hazard.
Fairness dictates that rebates should be based on past
contributions to the fund. Allowing the FDIC to pay rebates
would create a self-correcting mechanism to control the growth
of the fund.
Recommendation four--the Bank Insurance Fund and the
Savings Association Insurance Fund should be merged. The FDIC
has recommended this for years, in large part because the
resultant fund would be stronger and more diversified.
Recommendation five--deposit insurance coverage should be
indexed for inflation so that deposits do not see the real
value of their coverage erode over time. While the Congress
should decide on the initial coverage level, indexing would
provide a more systematic method of maintaining the real value
of deposit insurance coverage.
I would like to thank you, Mr. Chairman, and all the
Members of the Committee once again for the opportunity to
testify today and to present the FDIC's reform proposals, and
also for your very kind and supportive words. I hope that this
Committee and the Congress, working with my successor, will be
able to address these issues and bring about the needed
reforms.
In closing, I also would like to thank my colleagues at the
FDIC who produced the reform recommendations and so work so
incredibly hard to ensure a safe and sound financial system for
the American people. It has been a pleasure and a privilege to
work with all of you and with them.
Thank you.
Chairman Sarbanes. Thank you very much.
I might just note that the hearing on Donald Powell, who
has been nominated by President Bush to become the Chairman of
the FDIC, will be held here next Tuesday morning at 10 a.m.
Once he has a chance to settle into his position and is part of
the hearing process that Senator Johnson mentioned, I assume we
will then have him back before us again to discuss in
substance--we will get as much out of him as we can next
Tuesday.
[Laughter.]
He is the new boy on the block, and I am sure we will have
to give him a little time to settle in and then bring him back.
Ms. Seidman.
STATEMENT OF ELLEN SEIDMAN, DIRECTOR
OFFICE OF THRIFT SUPERVISION
U.S. DEPARTMENT OF THE TREASURY
Ms. Seidman. Thank you.
Chairman Sarbanes and Members of the Committee, it is a
pleasure to be with you today to bring you up-to-date on the
state of the OTS-supervised thrift industry. It is a particular
pleasure because the current state of the industry is in such
stark contrast to its condition not very long ago.
As of the end of March 2001, OTS supervised 1,059
institutions, with $953 billion in assets. That is about 10.7
percent of all depository institutions and 12.5 percent of
assets. And yet, in 2000, and again in 2001, thrifts originated
over 20 percent of all one- to four-family mortgages made in
the United States, including mortgages made by nondepository
institutions. Over 48 percent of aggregate thrift assets are in
whole one- to four-family loans. Ninety percent of all thrift
institutions hold under a billion dollars in assets and 43
percent are smaller than $100 million. These are your community
banks.
Almost 40 percent of the institutions are still in mutual
form, although they hold only about 7 percent of industry
assets. These institutions have a particularly strong community
orientation, which I know many of you are personally familiar
with.
During 2000, the industry earned $8 billion, a pace that
continued in the first quarter of this year with earnings of
$2.16 billion. Return on assets stood at 91 basis points for
2000, 92 basis points for the first quarter of this year, and
has been over 90 basis points for the last 3 years, a feat not
accomplished by this industry since the late 1950's.
Increasingly, earnings are coming from sources other than
net interest margin. Whereas, in 1990, noninterest income as a
percent of gross revenue was 5.1 percent, it was 12.4 percent
at the end of 2000. Thrifts hold an increasing number of
noninterest-bearing deposit accounts. That is, checking and
other transaction accounts that provide both a relatively
inexpensive funding source and a source of fees, and manage
over $420 billion in trust assets compared to just under $14
billion just 5 years ago.
Equity capital stands at 8.1 percent of assets and 98
percent of the institutions are well capitalized. Asset
quality, as would be expected in an industry heavily
concentrated in one- to four-family mortgages, is
extraordinarily good, with troubled assets at 0.6 percent of
assets in the first quarter and charge-offs at 0.19 percent.
While there has been some increase in noncurrent loans,
primarily in the 10 percent of thrift assets that consist of
commercial, construction, and nonresidential mortgage loans,
recently we have seen a decline in loans 30 to 89 days past
due.
Moreover, good asset quality has been accompanied by a
marked reduction in interest rate risk, which is the bane of
the traditional thrift institution. As of the end of the first
quarter, 73 percent of all thrifts were classified as low risk
for interest rate sensitivity, 18 percent medium risk, and only
9 percent as high risk.
Since 1989, OTS has had in place a stress test based
supervisory strategy for evaluating the interest rate risk of
all institutions we regulate. As a result, both we and the
institutions we supervise are able to quickly assess and deal
with any increase in interest rate risk sensitivity, whether
resulting from changing interest rates or from funding from
noncore deposit sources, including Federal Home Loan Bank
advances with embedded options.
The number of problem institutions, those with CAMELS
ratings of 4 or 5, remains low at 14, with only 0.5 percent of
industry assets. The number of institutions with CAMELS ratings
of 3 showing some weakness, particularly weaknesses that have
not been corrected as a result of prior exams, increased during
1999 and 2000, as was consistent across both the thrift and the
banking industry, but has recently started to decline. And 91
percent of the 90 3-rate institutions are well capitalized,
which means they have a capital cushion that will enable them
to work out their difficulties in an orderly manner.
Supervision at OTS is the responsibility of our 5 regional
offices. All of our examiners--safety and soundness,
compliance, information technology, and trust--work out of the
regions and are supervised by experienced regional directors.
However, through two unique supervisory tools, OTS maintains
consistency across the country and with agency policy, enhances
interagency communications, and stays on top of developing
events at high-risk or high-profile institutions.
Ten times each year, the most senior D.C. supervisory and
legal staff, including me, get together with the 5 Regional
Directors. We discuss current issues and problems, develop
policies that are effective because they are developed by the
people who will actually implement them, and resolve
differences.
Our other unique supervisory tool is the regular use of
videoconferencing between Washington and the regional offices
to discuss high-risk or high-profile institutions. We do this 3
times a year for each region, a total of 15, 2 to 5 hour
sessions, with each regional director and his senior staff and
senior D.C. supervisory and legal staff, and cover well over a
100 institutions annually. We use these sessions primarily to
make certain that supervisory strategies are effective and are
being stepped up where problems linger.
We have also spent a good deal of time over the past 2
years working with the institutions we regulate to help them
focus on long-term profitability. This is particularly
important in the increasingly competitive financial services
environment, where there is a tremendous temptation to reach
for yield without proper planning, systems, monitoring,
reserving or capitalization. This can lead not only to
financial difficulties, but also to violations of laws designed
to protect consumers.
During 1999 and 2000, we held 5 directors' forums, one in
each region, in which we reached a total of 1,275 thrift
directors. In these forums, we discussed the responsibilities
of a director, including the responsibility for the
institution's long-term strategic direction. This April, 450
thrift directors and CEO's joined about 50 OTS senior
supervisory staff for a conference focused entirely on long-
term profitability, in a world that is not only changing at a
rapid pace, as evidenced by the 2000 census, but that has also
gotten far more difficult for community banks.
The coming years will continue the challenges for both
thrifts and OTS. As we discuss in more detail in the written
testimony, issues such as the effective implementation of
functional regulation, deposit insurance reform, and better
aligning the thrift charter with the modern-day realities of
thrifts' role as strong retail lenders and providers of retail
services, will merit our attention, and yours, over the next
period.
In summary, I am very pleased to report that both OTS and
the institutions it supervises are strong and prepared to meet
the challenges ahead. I will be happy to answer your questions.
Thank you.
Chairman Sarbanes. Thank you very much.
We have been joined by Senator Bayh since we had the
opening statements. Before we go to questions, Evan, did you
have any comments?
COMMENTS OF SENATOR EVAN BAYH
Senator Bayh. Thank you, Mr. Chairman. I will wait my turn.
But I am grateful to our distinguished guests for appearing
before us today and I appreciated their comments.
Chairman Sarbanes. I am struck by the improvement that I
think has taken place within the regulatory agencies in terms
of putting oversight systems into place as you interact with
the private sector, and also by the developments that are
taking place in the private sector, to which Chairman Greenspan
and others alluded. I just want to ask some very basic
questions of the agencies.
You cannot function well if you do not have competent,
expert staff. So, I want to address the staffing problem of
your agencies. I want to make a few observations with questions
and let you respond as you see proper in terms of your
personnel.
First, there have been a number of stories and estimates
that a large percentage of employees at key Federal agencies
are going to retire soon. They are approaching eligibility for
retirement, leaving the agencies with significant operational
problems, as well as a loss of institutional knowledge and
human capital. Do you know what percentage of your agency
employees will be eligible to retire within the next 5 years?
In your estimates, what percentage are likely to actually
retire? And what, if anything, is being done to address this
potential problem?
Second, a recent paper published in The American Economic
Review said that the number of newly minted Ph.D's in economics
who are American citizens might fall below 300 by the year
2005, in stark contrast to about 600 in the late 1980's and
early 1990's. Senator Gramm's degree is assuming more and more
of a scarcity value here.
Senator Gramm. The good students are now foreign-born.
[Laughter.]
When Alan and I got out, the quality started down.
[Laughter.]
Chairman Sarbanes. What steps are your agencies taking to
assure their ability to recruit and retain economists who are
qualified to understand the complex risk-management associated
with modern financial institutions?
Third, we have received reports that some agencies have had
persistent problems holding on to experienced examination
staff. What are the causes of this brain drain and what steps
are you taking to retain your expert personnel?
Finally, in recent years, the FDIC, the OCC, and the OTS
have been reducing their staffing levels, as I understand it.
How does this impact your agency? Do these reductions make
sense in the face of increasing industry consolidation,
resulting in ever larger and more complex financial
institutions? Do these reductions make sense in the context of
an economic slowdown with some of the problems that come with
such a slowdown, to which you have alluded in your testimony? I
would be interested in hearing from each of you on this
staffing question. Mr. Chairman, why don't we start with you?
Chairman Greenspan. I think there are 2 major forces in
addition to the issue of the longevity question, which I think
varies by organization.
One is the major shift, in fact, accelerated shift, toward
high-tech type of evaluations within the banks of their loan
portfolios; and second, the need for supervisors and regulators
to obviously be fully conversant with the technologies that are
involved and the conceptual issues that have arisen over the
years in advanced risk-management.
There are remarkably few people out there who are really
very well skilled in this area and they are obviously in high
demand. We are fortunate in that we have a few and, in a
certain sense, you only need a few, to understand what
effectively is happening within the banks and what type of
oversight is necessary with respect to the technologies that we
confront.
I do not think we can out-compete, in a financial sense,
the prices, the wage levels, the compensation, that a number of
these people will get in the financial community, but we do
find that there are enough dedicated people who wish to work
within, for example, the Federal Reserve, and I presume in the
other agencies, because the work is exceptionally interesting.
It is an interesting, different type of supervision and
regulation than we have had in decades past.
So, I do think there is a problem. I do not, at least from
the point of view of the Fed, sense that we are in any way
falling short in our capacity to keep up with the ever-
increasing conceptual needs of supervision and regulation. But
it is a never-ending task, and I would suspect that we have to
keep up with it in a way which on occasion we may find
ourselves falling behind the curve, but for the moment, the
best way I can tell is I do not get a number of memoranda
coming through my desk which indicate problem X, problem Y,
problem Z. And that is usually a fairly good measure because,
believe me, when we do have problems, my ``in'' box gets filled
up.
Chairman Sarbanes. Mr. Hawke.
Mr. Hawke. Mr. Chairman, let me start by saying that I am
constantly in awe of the quality and dedication of the people
at the OCC. We really have an outstanding workforce that is
tremendously dedicated. I think that is demonstrated by the
fact that a great many of our senior people are well beyond the
time when they could retire, and for the reasons that the
Chairman was just explaining, stay with us and continue to make
an enormous contribution.
The average experience of our examiners is 13 years. That
means we have a substantial number of very experienced
examiners. On the other side of that coin is that we also have
a substantial number of examiners who have not lived through
troubled times in the banking system.
Many of our examiners were not on board during the time of
real stress in the system in the late 1980's and early 1990's.
One of the things that we have been doing recently in the face
of increasing problems with credit quality is training our
examiners to understand better how to identify and respond to
risks of a sort that they have not seen before in the system.
We have made some reductions in the staff, largely to
achieve efficiencies in the organization. We are exploring ways
of using technology to increase the efficiency of our
operation. We initiated a project that we call ``Supervision In
The 21st Century.'' We are running a pilot project with a
number of banks now to see how we can use technology to
decrease the amount of time that examiners have to spend on the
road and increase the efficiency of the information flow to our
examiners. So we are trying to make our operation more
efficient and increase its effectiveness at the same time.
In terms of recruiting, which was another part of your
question, we have increased our recruiting at college campuses.
We are making a special effort to increase the diversity of the
pool of candidates from which we draw examiners. That is
something we consider to be very important.
Chairman Sabarnes. Thank you.
Ms. Tanoue.
Ms. Tanoue. Mr. Chairman, you touched on a real challenge
that exists at the FDIC. On the one hand, we have been trying
over a number of years to reduce the workforce commensurate
with the workload. On the other hand, we recognize that over
the next 5 years, probably about 20 percent of the workforce
will be eligible for retirement.
What we have been trying to do, as we downsize the
workforce is to cross-train and provide additional development
opportunities for people, say, that are in the liquidation
area, that are not currently very busy, to train them in other
areas that they might be ready to step up to. We have also kept
an inventory of those people who do retire and their specific
areas of expertise.
In terms of economists, we also have stepped up the
recruiting. We recruit and interview at the American Economic
Association's annual meetings and actually, this year's meeting
in New Orleans was extremely successful.
In terms of the recruitment and retention of examiners, as
the Comptroller mentioned, we too have increased our recruiting
efforts and are trying to increase the diversity within our
workforce. We have not encountered significant problems in
terms of recruiting examiners.
In terms of retention, we have a concerted effort to make
sure that our employees, whose talent and expertise is
immeasurable, feel valued. I think that sometimes is more
important than the levels of compensation, particularly in
public service.
Chairman Sarbanes. Thank you.
Ms. Seidman.
Ms. Seidman. Thank you. I too want to emphasize the public
service element of the situation. Currently, 30 percent of OTS
employees are over age 50 and 12 percent are over 55. Those are
some of our very best employees. Because of the pension system
we have, they have been eligible for retirement actually for
quite a while now. And yet, they are staying. And they stay
because they believe in what we do and because we work very
hard to make sure that they continue to improve and continue to
increase their abilities.
When I first came to OTS, we had not hired in 7 years.
Needless to say, with a workforce that had gotten older, that
was not a long-term, stable situation. I immediately put into
effect an examiner recruitment and training program, which has
been quite successful over the course of the last several
years. We have been able to add quite a number of examiners to
our workforce, many of whom are second-career people.
We use a combination of classroom training and mentoring,
so that we can take advantage of the skills, the knowledge and
also, the experienced bank examiners' ``sense of smell.'' Our
more experienced examiners tell me, and I believe them, that
they can walk into an institution and sense something is wrong
pretty quickly. We are trying to impart that to the younger
examiners. We have a professional development program that is
available to all of our employees and that is extremely
successful.
What we find, frankly, is the reason we lose examiners is
the travel. It is a very hard life. And so, we have worked very
hard to increase tele-commuting opportunities and to increase
other opportunities for examiners to work closer to home or in
their home, while simultaneously never losing sight of the fact
that if you are not in an institution when you examine it, you
are going to miss stuff. There has to be a balance there.
On the staffing reduction, yes, we have recently had a
staffing reduction. It was done entirely in Washington. We have
worked very hard to make certain that our staff in the field,
from which all our exams are done, as I pointed out, has stayed
strong and at full force.
We have done more and more work across regions. We had
about 800 days of examiner time in 2000 where examiners worked
out of region. And while that seems to contradict the concerns
about travel and tele-commuting, it is a real opportunity for
them to see different places, different ways things are done
and to learn new things, and they value that also.
So this is not an easy question. It is one that we work
enormously hard at and that, frankly, has been one of the
things that I have worked hardest at since I have been at OTS.
But it is an area that I think we have a good handle on.
Chairman Sarbanes.Thank you. I have other questions. I will
reserve them until the second round.
Senator Gramm.
Senator Gramm. Well, Mr. Chairman, let me thank you again
for the hearing. Let me say that I do believe, and I am
convinced, that there are a lot of dedicated people who want to
work for the Government. I can hire people from MIT for $18,500
because it is cheaper than going to graduate school.
[Laughter.]
But the point is they are here to punch their ticket and
they are going to be gone. I do think it is important to have a
few people with gray hairs on their head around. We do have a
pay problem and it begins on the Board of Governors of the
Federal Reserve, not the Chairman, but members. I can
personally say that people that I thought should be appointed
to the Board have refused to be considered, in part, because of
pay. I think we are very foolish in government when we are
tight with paying people good salaries. I would rather have
fewer people that are better paid and more competent, than to
have big agencies. I just wanted to throw that in.
I have two questions: one that I would like to ask you,
Chairman Greenspan, and then one I would like to ask everybody.
I am concerned about the GE-Honeywell problem and the
action by the European antitrust division to question the
merger. Even though being domiciled for an international
company is not as relevant as it once was, by traditional
definitions, these are both American companies.
Maybe I am overreacting to that. As I am sure you are
aware, Mr. Chairman, in April, the European Union proposed a
financial conglomerate directive basically concerning financial
conglomerates operating in Europe. They raised, at least in a
formal sense maybe for the first time, the question about
whether to accept the regulatory supervision and decisions of
the home country regulators or whether to actually go behind
that in exercising regulatory authority over the conglomerate
if much of it is in another country, outside Europe.
Now, I understand that these are problems that we are going
to have to come to grips with because the plain truth is there
is no such thing as an American company any more. These are
world companies. But I would like to get your thoughts about
this and, particularly, any concerns you have about it.
Chairman Greenspan. Senator, I think we are dealing in this
area with some of the very deep cultural values of differing
countries. The issue of bankruptcy, for example, seems to be a
technical one. We have, however, very great difficulty unifying
international bankruptcy codes, largely because the view of
debtor-creditor relationships is a deep-seated view of
fundamental relationships in a society. And I can tell you the
differences that we have run into in that particular regard are
really quite surprising.
The same thing exists, as far as I can judge, in the
antitrust area. In the United States, for example, our
fundamental premise is the health--I should say, the advance--
of consumer interests and that all focuses on enhancing
competition, which is fundamentally the underlying rule of all
American antitrust statutes. We do not, for example,
particularly try to protect the competitors of individual firms
who are involved in antitrust suits. Our focus is solely on the
consumer.
That is not true in Europe. And it is not true in a lot of
places, that there is a fundamental view about the nature of
competition, in some cases, classified as cutthroat and
therefore undermining the stability of the society and its
values. Since it is increasingly very difficult to
differentiate the nationality of individual conglomerates, I
think somewhere down the line major antitrust jursdiction are
going to have to reconcile their differences. But I do think
that the issue you are raising is an important one and one
which must be resolved if we are going to continue to get the
benefits of globalization, which, in my judgment, are many.
Senator Gramm. Well, I would just like to say, and I won't
ask my second question because I have run out of time, but I am
especially concerned about the action of the European Union
because they have adopted a privacy policy that is unworkable,
and as a result, they want to impose it on everybody else.
We can question the logic of their environmental policy and
their regulatory policies. But my concern is that we do not end
up having bad policies imposed on us as Europeans try to
protect themselves against competition when they have lost
their competitive edge based on their policies that they have
implemented either through their super-national government or
at the national level. This is something that we are going to
have to look at very closely.
I thank you, Mr. Chairman.
Chairman Sarbanes.Thank you, Senator Gramm.
Senator Johnson.
Senator Johnson. Thank you, Mr. Chairman. I appreciate you
raising the issue about staffing. I wear another hat in the
Appropriations Committee and this is an issue of concern to me
as well.
Chairman Tanoue of the FDIC, on April 5, made 5
recommendations which she again restated here today. That is,
the merger of the bank insurance fund and SAIF, indexation of
insurance coverage, changing the premiums on institutions'
risk, risk-based premiums, shift from a designated reserve
ratio of 1.25 to a target level, and a rebate based on historic
contributions.
I would like to put the question to Chairman Greenspan and
Comptroller Hawke and Director Seidman about the impact on the
banking and thrift industries of implementing the FDIC's
proposals for risk-based premiums, the merger of BIF and SAIF,
and the raising of the insurance per-deposit account. And I
wonder if you could just briefly share some thoughts with me on
those three points in particular.
I have an 11:30 a.m. commitment that I cannot avoid and I
may wind up leaving before all of the answers are made. But I
want them on the record. And I appreciate the insights that you
might be able to share with us.
Chairman Greenspan.
Chairman Greenspan. Senator, I think that Director Tanoue
has raised some very thoughtful issues with respect to the
question of deposit insurance and its impact on the economy.
These are very important issue which we at the Federal Reserve
Board have not considered as a board. I think it would be
better that I address those issues in the context of speaking
for the Board, which I cannot at the moment, rather than for
myself. So if you would like an official response from us, I
would be fairly glad to provide that in writing.
Chairman Greenspan official response:
You asked about the impact on banks and thrifts of the
implementation of three FDIC proposals.
Risk-based premiums: The FDIC recommends that the current
statute be amended to permit it to adopt a more flexible risk-
based premium plan, with premiums based on a large number of
variables that research suggests are related to the fund's
exposure. We support that proposal.
A robust risk-based premium system would be technically
difficult to design. However, the Board believes that the
potential benefits are worth the effort. A tighter link between
insurance premiums and risk exposure to the fund would, by
affecting the ex ante behavior of banks and thrifts, reduce
moral hazard and the distortions in resource allocation that
accompany deposit insurance. Risk-based premiums would be
another factor increasing the cost of risk taking and simulate
what the private market would do to the cost of deposits if
there were no deposit insurance.
However, to be effective in changing behavior and to
reflect differences in risk exposure, the range in premiums
would have to be significant. Capping risk-based premiums, say,
as the FDIC suggests, at about 30 basis points, in order to
avoid inducing the failure of weak entities, would sharply
reduce the benefit of the proposal. The Board believes that
capping premiums may end up costing the insurance fund more in
the long run should weak institutions fail anyway, with the
delay increasing the ultimate cost of resolution. We would thus
recommend that, if a cap is required, it should be set quite
high so that risk-based premiums can be as effective as
possible in deterring excessive risk-taking.
Merger of BIF and SAIF: We support the FDIC's proposal to
merge the BIF and SAIF funds and believe that the public and
both sets of depository institutions would be better off if
this merger occurred. Because the charters and operations of
banks and thrifts have become so similar, it makes no sense to
continue the separate funds. The insurance products provided to
the two sets of institutions are identical and thus the
premiums should be, as they are today, identical as well. Under
current arrangements, the premiums could differ significantly
if one of the funds fell below the designated reserve ratio of
1.25 percent of insured deposits and the other fund did not.
Merging the funds would also diversify their risks and reduce
administrative expenses.
Per-deposit account insurance limit: The Board does not
support the FDIC recommendation to index the current $100,000
ceiling on insured deposits.
We can see no evidence that depositors are disadvantaged by
the current ceiling. Depositors who want more insured deposits
are adept at opening multiple accounts, which is consistent
with standard investment advice to diversify asset holdings.
The trend for some time has been not only for households to
diversify among deposit issuers, but also to diversify their
holdings among different types of financial assets as
attractive new market instruments have developed. There has
been no break in that trend that seems related to any past
change in insurance ceilings and it seems doubtful to us that
the shift from deposits to equities that was so significant in
the late 1990's would have been affected at all by a higher per
account ceiling. Indeed, the weakness in equity markets in
recent months has been marked by an increase in deposit flows
to banks and thrifts.
Depositories do not seem to have had any significant
problems raising funds under the current ceilings. Indeed, the
smaller banks, which one might have expected to have the
greatest difficulty, have had the most success. Adjusted for
bank mergers, in the second half of the 1990's the smaller
banks have grown more rapidly and--at over a 20 percent annual
rate of growth--have increased their uninsured deposits at
almost twice the rate of the largest banks. Clearly, small
banks have a demonstrated skill and ability to compete for
uninsured deposits.
The Board has concluded that, with no evidence of harm to
the public or to depositories, and with no evidence that
indexing is needed now to stabilize the banking or financial
system, there is no reason to expand the moral hazard of the
safety net by indexing the insured deposit ceiling. There may
come a time when the Board finds that households and businesses
with modest resources are finding difficulty in placing their
funds in safe vehicles and/or that there is reason to be
concerned that the level of deposit coverage could endanger
financial stability. Should either of those events occur, the
Board would call our concerns to the attention of the Congress
and support adjustments to the ceiling by indexing or other
methods.
Senator Johnson. I understand your point of view on that,
Mr. Chairman, and I would very much appreciate presenting this
issue to the Board and--
Chairman Greenspan. I can answer the economic issues, but
not without getting into the implications of where the Board
may or may not come out with respect to her thoughtful
recommendations.
Senator Johnson. Very good.
Mr. Hawke.
Mr. Hawke. Senator, I am quite supportive of the idea of
risk-based premiums. Of course, I sit on the FDIC Board and
participate to some extent in the formulation of the FDIC's
proposals. There are some points of difference that we have
with the FDIC on some aspects of it, but I would say nothing
fundamental.
On the question of deposit insurance coverage limits the
jury is still out. It is not clear to me whether increasing
deposit insurance coverage limits is going to have the effect
that many community banks, in particular, hope it would have,
which is bringing new deposits into the system. I am concerned
that it may just result in a shifting of deposits among banks
as opposed to bringing new deposits into the system. I would
have less concern about coverage limits in an environment of
fully risk-related premiums.
One issue that is of major concern to us is the fee
disparity between State and national banks, which we think
should be addressed in the context of deposit insurance reform.
Right now, national banks pay essentially the full cost of
their supervision. Yet, State banks pay only about \1/10\ of
the cost of their supervision. They pay for what the States
provide, but they pay no share of the cost of their Federal
supervision. In the case of State nonmember banks, that cost is
taken out of the deposit insurance fund, between $500 and $600
million a year, which creates a significant inequity between
State and national banks. We think this is an issue that needs
to be addressed in the context of deposit insurance reform.
Senator Johnson. And Ms. Seidman.
Ms. Seidman. Yes. Let me just say that I, as a Member of
the FDIC Board, have also been enormously supportive of the
efforts of Chairman Tanoue and the staff. It has been a process
that I think has moved a very, very important issue to the
front burner and focused us in on some of the major problems.
I believe that the issues of risk-based pricing and the
procyclicality of the system are issues we need to deal with
and we need to deal with them well and we need to deal with
them reasonably quickly and we need to deal with them in a
comprehensive fashion.
I have been in favor of merging the funds for as long as I
have had an opinion on any of these subjects and my opinion
certainly has not changed as the SAIF has increased above the
BIF in its reserve ratio. The merger is the right thing to do.
These 2 funds at this point insure exactly the same kinds of
institutions. Two of the 5 largest institutions in the SAIF do
not have a thrift in their corporate family.
In terms of raising the insurance limit, I am basically
where the Comptroller is. I do think the jury is out. I think
there is a real issue about whether this would just result in
more money flowing into things other than community banks.
I think there is an issue about what we really believe
deposit insurance is about, that is, a policy decision for the
Congress to make. Finally, I think most importantly, unless we
have true risk-based pricing, I do not think that issue should
even be discussed.
Senator Johnson. Thank you, Mr. Chairman.
Chairman Sarbanes. Thank you.
Senator Shelby.
Senator Shelby. Thank you.
I want to follow up on the insurance. Would you discuss the
risk of the merger of the funds versus the upside? What are the
risks if you merge the funds? What are the risks out there? I
do not see any.
Ms. Tanoue. There are none.
Senator Shelby. There are no risks.
Ms. Tanoue. No. Simply put, a merger of the funds would
result in a stronger, more diversified fund.
Senator Shelby. Ms. Seidman.
Ms. Seidman. Absolutely. There is no risk to not doing it
and there are risks to leaving it the way it is.
Senator Shelby. And the risks to leaving it the way it is.
Ms. Seidman. There are essentially two risks to leaving it
the way it is. One is that the funds are indeed less
diversified than they would be if merged. Bank of America, for
example, I think has something close to 9 percent of the BIF,
and a significant portion of the SAIF. Even though it has a
significant portion of the SAIF, combining the two would drop
it down. Washington Mutual would come way, way down in terms of
exposure. So with merger, the fund would have much less
exposure to the largest institutions.
The second risk that is out there is, and as Chairman
Tanoue has testified, that the BIF has been dropping in its
reserve ratio at the same time the SAIF has been stable. If
that trend continued, you could end up back where we were in
1995, although, of course, it would be reversed, and you would
see a situation where institutions with BIF-insured deposits
would be paying big premiums and institutions with SAIF-insured
deposits would not be. That is a very bad situation.
Senator Shelby. Do you want to add anything?
Ms. Tanoue. I agree. The greatest threat is the potential
for premium disparity. And many members on this Committee are
familiar with that experience.
Senator Shelby. We have talked about this in this Committee
for many, many years on other occasions. But most insurance
that I have ever heard of is based on risk, is not it?
Ms. Tanoue. Absolutely.
Senator Shelby. I mean, it is based on the underwriting of
a risk, except to a certain degree, the FDIC.
Ms. Tanoue. That is a central recommendation that we put
forward--to put into place a more effective risk-based pricing
system for all insured institutions, all of whom present risk
exposure to the fund.
Senator Shelby. What is the current strength of the FDIC
fund? Where do you stand today as far as the value of it? What
is the size? Roughly.
Ms. Tanoue. The BIF balance is slightly in excess of $30
billion.
Senator Shelby. Thirty billion dollars.
Ms. Tanoue. And SAIF balance is slightly in excess of $10.
So something in excess of $40 billion combined.
Senator Shelby. Do you think that is adequate reserves?
Ms. Tanoue. Well, the issue of what level the fund should
be is a perennial one and a very important one. There really is
no set answer to that question. It always involves a trade-off
in terms of what level of risk you want to cover, what you feel
is sufficient to protect taxpayers versus whether you want a
fund to be growing and growing and growing, or whether you want
some of those monies to be returned back to communities to be
put to good use.
Senator Shelby. You were both talking about upping the
coverage limit on the Bank Insurance Fund. There are certain
risks there, are there not? If you run the limits up from
$100,000 to, say, $300,000, there could be risks to the
taxpayer regarding that down the road, could there not?
Ms. Tanoue. Yes Senator, there is a concern about increased
moral hazard.
Senator Shelby. Absolutely.
Ms. Tanoue. And Ellen Seidman just made a very important
point. That is, we believe very strongly that the issue of a
coverage increase should not be considered in and of itself.
The issue of risk-based pricing must be taken into
consideration first before any kind of discussion of the
coverage increase is considered.
Senator Shelby. I agree with you.
Thank you, Mr. Chairman
Chairman Sarbanes. Thank you, Senator Shelby.
Senator Reed.
Senator Reed. Thank you, Mr. Chairman.
One of the reasons the financial system is so strong is
that the economy has been strong in the last several years. But
there are some potential developments. One is an ominously low
household savings rate. And the second is with our tax policy
now, we have lessened the surplus, which in a sense is public
savings. Without savings, it is hard to form capital.
We are also beginning to see some deterioration of the
robust productivity numbers of the last several years. All
together, your view with respect to how the banking system is
going to cope with what seems to be an inability for American
households to save.
Chairman Greenspan. The problem of savings has been a major
problem in this country for a very protracted period of time,
Senator. And as you know, as a consequence of that, we
effectively are borrowing a significant amount of savings from
abroad, which is our current account deficit.
The reason it hasn't shown up as a significant economic
problem is that we have really an extraordinary degree of
productivity from our savings in the sense we have managed to
use the limited amount of savings, in a very effective way, so
that the type of capital which we are producing has tended to
be the high productivity-producing capital.
So in part, because of our financial system and, indeed,
our banking system in general, we have been able to direct the
limited savings that we do have into the most effective uses.
In that regard, one must look at the American banking system as
a very major player in our ability to improve productivity over
the years with, as you point out, quite a diminished level of
domestic savings.
Part of that is the result of the fact that we have created
a very flexible system and we are able to allocate resources in
a most effective manner. Is that going to continue indefinitely
in the future? For the moment, I would suspect, yes. But in the
distant future, I think that remains to be seen.
Senator Reed. I wonder, Mr. Hawke, Ms. Tanoue, Ms. Seidman,
if you have a comment?
Mr. Hawke. Senator Reed, one aspect of the problem that you
have mentioned concerns us and that is the deterioration in the
core deposit base of banks, particularly community banks. Our
community banks tell us that loan demand remains strong, but
their ability to raise traditional core deposits is declining.
They are increasingly turning to other sources of liquidity, in
particular, the Federal Home Loan Bank system. That has raised
some concerns of its own for us. But I think it is important
that liquidity of community banks be considered and addressed.
It is an important issue that we hear about everyday.
Senator Reed. Chairman Tanoue.
Ms. Tanoue. Our testimony places a great emphasis on that
point as well. But I would add that there is some evidence that
liquidity pressures are easing. In the last two quarters, we
have seen a tremendous in-flow of deposits. It would be very,
very important to keep an eye on that and to see whether that
is sort of a blip in terms of against a trend or whether it is
a new trend.
Senator Reed. Do you have any sort of indication what is
causing this influx of deposits, initially?
Ms. Tanoue. Essentially, it is a return by consumers to
safer havens for their money.
Senator Reed. Ms. Seidman.
Ms. Seidman. Our testimony also discusses the liquidity
issue and I think it is a real one. We just put out a bulletin
yesterday on managing liquidity risks. But I want to take a
little different tact here.
We have all spent a lot of time over the last several years
thinking about underserved communities and about the role of
the banking system with respect to the underserved communities.
Frankly, for a lot of the small community institutions, that is
where their future is.
In many of those communities, savings are in the mattress.
Money is in the cookie jar. I think it is really important for
our bankers and, again, particularly community bankers, to be
reaching out to those communities, not just to make one-off
loans, but to bring those people fully into the financial
services mainstream with deposit products and investment
products, as well as loan products.
I noticed there was an article in today's New York Times
about this. It is an issue that we have discussed with any
number of our institutions. It is obviously not going to make
the savings rate jump way up. But it could provide some greater
stability to consumers toward the bottom of the economic
spectrum.
Senator Reed. Thank you very much.
Thank you, Mr. Chairman.
Chairman Sarbanes. Senator Bunning.
Senator Bunning. Thank you.
My gosh, I had very few questions and now I have listened
to everybody else's and I have lots more. Let me just start out
with what Senator Gramm talked about in keeping good people.
The Federal Reserve Board appointees have 14 year terms. Is
that correct?
Chairman Greenspan. That is correct, Senator.
Senator Bunning. That is almost as good as a Federal
district judge. It just depends on what age you are appointed.
[Laughter.]
Those funds that we are paying that 14 year term to are
substantial. So, I disagree with Senator Gramm. I think we are
paying our people adequately, like we do pay our Federal
district judges and our appellate judges.
I want to ask you the question I always ask you, Chairman
Greenspan, about inflation. Any new or striking points of
inflation in the current economy and/or close future economy
you forsee?
Chairman Greenspan. It is very difficult to see anything
short-term, Senator. We do know that as the rate of growth has
slowed down, unit labor costs have gone up as they invariably
do in such a period. But we have seen no evidence that those
costs are being passed through into final prices in any
material way.
Similarly, we see a fairly extraordinary increase in energy
costs. And here again, separating corporations into nonenergy,
nonfinancial, we have tried to trace the movement of energy
costs into prices. We find that almost all does not go into
final goods prices, but is squeezing profit margins, which is
the same thing as unit labor cost.
Our best measures of consumer inflation are the personal
consumption expenditure deflators which the Department of
Commerce produces. And here, the so-called core inflation
index, that is, total consumer inflation, less what we perceive
to be the volatile parts of food and energy, that so-called
core inflation has been relatively stable and shown no evidence
of it.
But having said that, I would suggest to you, as I always
do say, that we have to be very careful about any evidences of
emerging inflationary instability because history has told us
time and time again that the most effectively productive
economies are those with stable prices. And we certainly hope
to be able to see sufficiently far in advance to fend off any
emergence of inflationary forces.
Senator Bunning. Chairman Tanoue, you think that there
should be an increase, or at least that was one of your
recommendations to increase the amount of insured deposit. Did
I misinterpret that?
Ms. Tanoue. Actually, the FDIC has never taken a position
in terms of making a recommendation in terms of increasing the
coverage level. What we have recommended is that wherever the
Congress chooses to set that initial base level, we have
recommended that the level be indexed to inflation to maintain
the real value.
Senator Bunning. I know the Chairman did not want to answer
that because he has personally answered it before. He disagrees
that we should move from the $100,000 deposit insured savings
accounts. And I understand it is not a position of the Fed, but
it is a personal position, that you did not want to get into
that.
Chairman Greenspan. I think when the issue is put on the
table as potential legislation, which in effect that is what is
involved here, it should be the opinion not of the Chairman but
the opinion of the Board of Governors.
Senator Bunning. Okay. The BIF and SAIF funds, and I want
to follow up on my good friend, Senator Shelby--if there is no
risk, why in the world aren't we doing it?
Ms. Tanoue. That is a good question. I think, and many
people have advocated, that the merger of the funds occur. But
usually what happens, I think as a practical matter, is that
other issues are tied with the issue of the fund merger. But,
really, that is an essential change and it should be done.
Senator Bunning. But, I mean, are the community bankers,
are the larger bankers--who is stopping it? Because if it is
the right thing to do, there has to be some opponents out there
that are stopping it.
Ms. Tanoue. Generally, there are many issues relating to
deposit insurance reform, many of which are very complex. This
is an issue that is probably best taken up within a
comprehensive approach to these issues, and this is what we
have recommended.
Senator Bunning. Thank you very much.
Thank you, Mr. Chairman.
Chairman Sarbanes. Thank you, Senator Bunning.
Senator Corzine.
Senator Corzine. Yes. I think the BIF/SAIF combination begs
a question about whether there are greater efficiencies or
certainties to regulation that might come from a more broad-
based combination, particularly given the increasing
concentration of assets that might be in the thrift industry
and that $950 billion. One could at least ask that question. I
would love to hear comments on that.
But the main question I would like to hear is, some view
about the interconnectedness, the systemic exposures that you
all have mentioned in testimony, but it hasn't been followed up
with regard to syndicated loans, particularly I think in light
of nonfinancial institutions increasingly involved in the
lending process.
I think that was what Ranking Member Gramm was talking
about a little bit with respect to the GE and Honeywell merger.
But it is a problem that is of concern in New Jersey with one
of our telecommunications companies and I think with Nortel as
well.
I know that derivative risk is interconnected and systemic
of nature and has a credit element. I am concerned that these
kinds of things do not show up until you have one problem that
then cascades. And I am concerned that we are not focused as
much on this, at least in this discussion today, as I might be
if one were worried about the deterioration of credit quality
in a system basis.
I guess you could take that to some of the global,
sovereign institutions with what one might be concerned about
in Argentina or Turkey. I would love for anyone to comment on
both the general status of this. But how is the regulatory
structure or do you feel that we are adequately able to track
those interconnected points better than maybe we were at
another point in time?
Chairman Sarbanes. I think that is a very good question and
it is part of what we were trying to get at with this oversight
hearing. In other words, to start probing and looking ahead to
get some sense of things that are happening that may be new in
terms of appearing on the scene, what their implications are,
and how the regulatory system deals with it.
Mr. Hawke. Senator, I mentioned in my testimony the Shared
National Credit process, which is one of the principal
mechanisms the bank supervisors have for looking for the kinds
of credit exposure that you have described. In the Shared
National Credit process, we look at the syndicated credits of
over $20 million in size, and we have a very large number of
those credits this year. We do it jointly with the Federal
Reserve and the FDIC, so we all participate in looking at the
same credits. And we are trying very hard to make sure that we
are approaching them in a uniform way. But in that process, we
get well educated about where sectoral risks are and how banks
are handling these large credits. That process for this year
has not run its course yet, and we are awaiting the outcome of
this year's analysis.
Senator Corzine. Do you also look at derivative credit
exposures in that process or mostly at the--
Mr. Hawke. Not in the Shared National Credit process as
such, but we just put out a report this week on derivative
activities at our banks. The notional amount of derivative
activity has increased, but that really doesn't reflect what
the risk is in the area of derivatives. Rather, it reflects the
level of business activity.
Derivative activity is focused in a very small number of
very large banks. We and the Federal Reserve, I am sure, watch
that very carefully in the banks that we supervise. We have a
core group of experts who work with those banks. At the present
time, we do not have any great cause for alarm in that area.
Senator Corzine. Any of the other panelists like to
comment?
Ms. Seidman. I would just like to comment that while the
items that you have been talking about are very important for
the larger institutions, I think for the mid-size and smaller
institutions, the biggest risk that we see is this problem of
reaching for yield in an ultra-competitive world and moving
from one line of business for the day to another, never quite
really doing any of it well. And usually, we are able to get in
there on time and put a stop to it before people get over-
extended. But every once in a while, it moves very fast and
then it gets very hard to do.
Senator Corzine. Could I ask you to comment maybe on the
first question?
Ms. Seidman. On the first question? Okay. First of all, in
the thrift industry, the increasing concentration has in fact
diversified geographic risk, which is probably the greatest
risk for mortgage lenders. So, I do not think that it has made
the industry more risky.
In terms of consolidation, Gramm-Leach-Bliley was able to
get through after all those years because in many ways the
regulatory issue was not tackled. We now have a regulatory
systems in the financial services industry where the insurance
commissioners, the securities commissioners, the banking
regulators, not only us, but also all 50 of them in the States,
the SEC, are all intimately related.
We are working very hard, all of us, to make this system
work. For example, OTS has information-sharing agreements with
45 of the State insurance commissioners. But it is a difficult
system.
My personal opinion is that sometime in the course of the
next decade, it will be up to Congress to face up to those
difficulties.
Senator Corzine. Thank you.
Chairman Sarbanes. Senator Bayh and then Senator Miller,
and then Senator Schumer. Let me say that Ellen Seidman is
going to have to leave shortly. So if either of you have
questions specifically directed to her, you probably ought to
take that question now. But if not, Senator Bayh, why do not
you go ahead.
Senator Bayh. I hope you will not be offended, Ellen, if
the answer is no.
Ms. Seidman. It is quite all right. I know that the
Chairman is the really big draw here.
Senator Bayh. Mr. Chairman, I would like to thank you for
holding this hearing. One of our comparative advantages
economically as a country is our deep and broad and secure
financial markets, particularly our banking system. And we
neglect the stability at our peril. So I think this hearing is
very appropriate and timely.
I hope the other panelists won't be offended if I address
three brief questions to Chairman Greenspan building on
something that Senator Reed mentioned.
There was a recent analysis done by Goldman Sachs
suggesting that because of what they predict to be a decline in
capital investment, the productivity growth rates may average
\4/10\ of 1 percent less over the next decade than had been
previously forecast. It was their analysis that this would
translate into a $1.1 trillion reduction in the anticipated
surplus.
My understanding of the historic patterns of productivity
growth trends is that we have occasionally seen accelerating
productivity growth that we experienced over the last several
years. But that, invariably, it regresses to some sort of mean.
I am interested in your view on productivity growth going
forward and, in particular, Mr. Chairman, what this means for
the projected budget surplus.
Chairman Greenspan. The current services budget surplus has
essentially been based on a 2\1/2\ percent productivity
increase annually. The Goldman Sachs analysis brought it down
to 2\1/4\ percent, as I recall. They were coming originally
from 2\3/4\ percent. Those are disputable calculations. I will
say that there is not--
Senator Bayh. Would Senator Corzine agree with that?
[Laughter.]
Chairman Greenspan. I was purposely directing it at you,
Senator not your colleague on the right.
Senator Bayh. I appreciate that, Mr. Chairman. Thank you.
[Laughter.]
Chairman Greenspan. Besides, Senator Corzine is no longer
interested in that.
Senator Bayh. This is true.
[Laughter.]
Chairman Greenspan. I was about to say, however, there are
very legitimate questions with respect to how one comes at
these types of forecasts, and it was a fairly sophisticated
approach and I read it very closely. But you have to remember
that we economists go by issues rather quickly and sometimes
when you dig a little deeper, there are some open questions. So
just to say specifically that, in my judgment, I do not think
we are down that far. In other words, I would not agree with
the conclusion.
The issue of translating the change in productivity growth
into the surplus is relatively straightforward. But remember,
we are talking about current services budgets here. These are
the only adjustment to what is under current law a presumption
that discretionary expenditures go up with the cost of living,
a scarcely over-liberal interpretation of what usually happens
to these data.
So, I do not see any fundamental, long-term changes. In
other words, I do think that when a 2\1/2\ percent productivity
growth estimate came out, a lot of people thought it was overly
conservative. What one may readily argue at this stage is that
it is less conservative than it was at the time that it was
done. But I do not see anything in the data, per se, at this
particular point which should lead one to make any major
revisions in the current services surplus. Obviously, as the
Congress moves forward on taxes and on the expenditure side,
you shift to actual budget surpluses which are clearly going to
be less than the current services number.
Senator Bayh. Well, I am encouraged to hear your comments
about productivity estimates. My concern had been with the low
rate of personal savings combined with some of the recent tax
actions taken by the Federal Government that our margin for
error, the buffer that we had in this country with the size of
the surpluses, had been reduced. And if you combine that with
uncertainty and productivity growth, then perhaps we would then
have a fiscal problem somewhere down the line. The desire to
take some of the risk out of the projections through triggers
and things of that sort. But that is a debate that we have had
and we have moved on.
I would like to ask one other question before my time
expires. The robust growth in the U.S. economy has provided a
buffer for the rest of the world against such things as
financial contagion from Third World problems, long-term
capital problems, things of that nature. I would be interested
in your view, with the slowing of the U.S. economy, how much is
the vulnerability of the global economy increased to some of
these external shocks?
Chairman Greenspan. Senator, that is a very good question
which we have been focusing on for quite a while. One of the
problems that we have is that when you actually take
correlations of growth relationships--in other words, for
example, between the United States and Europe--we find a much
higher synchronization of the growth rates in Europe and the
United States than our very elaborate macromodels can generate.
Meaning that we can incorporate the trade accounts, we can
incorporate the financial flows, and a number of things which
are quite visible to us. And we put them together, try to get
evaluations of how they all affect the United States and
Europe, and then simulate various results from which we can get
a correlation between the growth rates, essentially what is
reflected in our models of the individual countries.
But when we look at what actually happens, the correlation
is much higher, which is another way of saying, we do not yet
fully understand all of the elements in the international arena
which are affecting individual countries. So whatever it is
that we think is happening, it tends to have a significantly
larger impact on our trading partners and what is happening
amongst our trading partners has a greater effect on the United
States than we can readily understand directly, which leads us
to be, obviously, quite sensitive to what we see going on
abroad. And indeed, we have put a great deal of effort in
trying to understand that in a way which we did not 20 years
ago when those relationships did not exist at the levels they
exist today.
Senator Bayh. Thank you, Mr. Chairman. Thank you to the
rest of the panel.
Chairman Sarbanes. Chuck, Chris was here at the outset and
for quite a while and went away. So, I will recognize him now,
and then you.
Senator Dodd. Thank you. Let me thank my colleague from New
York, too. I will be brief. Secretary Powell is testifying one
floor below you, so we are going back and forth here and
juggling and I apologize coming in and out of the room like
this.
I would like to turn the attention of all four of you to an
issue that I gather has not been raised in my absence, one that
I find very, very troubling and has recently come up in the
context of the bankruptcy bill debate, certainly in the Senate.
I do not believe the issue came up in the House, although it
may have. And that is, according to credit card issuers, of
course, bankruptcy reform is needed because far too many people
are defaulting on their credit card debts. As a result of these
defaults, obviously card issuers pass these costs on to other
credit card users, thereby raising fees and rates. Credit card
issuers have been extraordinarily persuasive, I might add, in
both the House and the Senate when coming to this bankruptcy
bill in terms of what is included. There has been very little
discussion, other than some amendments that were raised, about
the underwriting practices, when it comes to the issuers of
unsecured debt. And so, I would like to address your attention
to that issue, if I could.
I am told that under the present economic conditions in the
country and the slight downturn, there were reports this
morning, in fact, the national news media, that as many as 1.5
million Americans could end up taking the Bankruptcy Act this
year alone. And about a third of those will be people between
the ages of their 20's and 30's. In fact, an increase. Five
years ago, the American Banking Institute indicated that
personal bankruptcies were filed by only 1 percent of those
people under the age of 25. In 1998, the latest numbers I have,
that number is up to 5 percent. I do not know what the latest
numbers are, but it seems to me they are probably moving up
from what they were.
I recently offered some legislation in the context of the
bankruptcy bill that would say that for people who are under
the age of 21, that you would have to demonstrate, one, an
independent means of paying your debts or obligations, two,
have someone cosign for you, or, third--any one of these three,
not all three, but any one of these three--or proof that the
applicant had completed a certified credit counseling course,
some way of at least raising the level, raising the bar a bit.
Many of you in the past I know have taken the position that
loans made without consideration of an individual's ability to
pay constitutes unsafe and unsound business practices. So, my
questions are for you, one, are the credit card loans made
solely on the basis of a student ID and a signature? And that
is what the case is. I am not exaggerating this. Merely signing
a card and showing your student ID on a college campus will get
you a credit card.
I am told by colleges around the country that you are
looking at as many as 50 credit card applications arriving at
freshmen's doors at college. The debt now is going up near
$3,000, almost $3,000 per child. They are children in many
cases here. There is little or no responsibility being
exercised by the credit card companies, in my view. And so I am
very worried that this matter is going to get further out of
hand and add to further financial burdens of some of the most
vulnerable people as they have tremendous costs obviously
associated with higher education.
I am not suggesting any caps on fees or fixing interest
rates and the like. But it seems to me that there is a
commensurate responsibility, not only of the consumer, but also
of the credit card issuer when it comes to this ever rising
consumer debt question.
I wonder if you might comment on the wisdom that the credit
card companies are engaging in, whether or not this is unsafe
or unsound to be issuing credit cards to people merely on a
student ID identification and a signature, whether or not the
three criteria that I have mentioned you think raise too high a
bar for the credit card issuers to me. And I would appreciate
your responses. Mr. Chairman, can we start with you?
Chairman Greenspan. Jerry Hawke, I am sure knows more about
this than I, since he regulates a lot of these people. But that
gives me a wide open avenue to say irresponsible things, maybe.
Mr. Hawke. I know more about it because my son is one of
the recipients of those solicitations, and I happen to know a
lot about his capacity to pay.
Chairman Sarbanes. That is the way to be a fast learner on
that issue, that is for sure.
[Laughter.]
Senator Dodd. And we have had some very tragic stories, by
the way. At campuses that offer, by the way, who receive
thousands and thousands of dollars for exclusivity contracts on
college campuses. Every now and then we introduce bills and we
hear from constituent groups. This recieved relatively minor
attention. I cannot tell you the number of people I have heard
from around the country who agree that this is something--from
parents, primarily.
Chairman Sarbanes. Go ahead.
Mr. Hawke. I think practices vary, Senator, among
companies. I had the occasion just a few weeks ago to visit one
of our very largest credit card banks. And, unlike some others,
they underwrite every applicant individually. They have a
battery of people who make traditional kinds of credit
underwriting decisions on a case-by-case basis.
With others, it is much more a commoditized product. It is
done with credit-scoring on a much more mechanical basis. They
factor in loss rates and, as you pointed out, that all gets
included in the pricing.
There is one point that you made that I think is enormously
important, particularly in the context of a subject that we
have not talked about this morning: predatory lending. That is
the lack of underwriting and the extension of credit without
any consideration of a borrower's ability to repay. I think
that that is what lies at the heart of what we would generally
refer to as predatory lending. It is a situation in which
lenders--and these are not, for the most part, credit card
lenders, but other types of lenders, and for the most part,
nonregulated entities--target the equity that people have built
up in their homes, for example, and push credit out to them for
the purpose of trying to recover large fees ultimately from the
equity in their homes.
We have been putting great emphasis on the need to follow
traditional bank underwriting in all kinds of credit-granting,
that is, to assure that the applicant for credit has the
capacity to service and pay off the loan from conventional
resources without looking to the collateral that might be
pledged as the source of recovery. I feel confident that if we
can get that principle well established and well implemented,
it will go a long way to dealing with the subject of predatory
lending.
Senator Dodd. Do you think the criteria we placed is an
undue burden or too high a bar to require a credit counseling
course for someone that young an age might be required to take?
Is that too heavy a burden?
Mr. Hawke. I would be hesitant to express a view on that
because I am not entirely sure what--
Senator Dodd. If we cannot get your view, whose view do I
get? You are the people who are going to be responsible for
this sort of a thing. If we are going to make the case, who do
I rely on if I cannot rely on you folks to give me an answer to
this?
Mr. Hawke. I think part of the answer to the problem of
predatory lending and other kinds of lending that involve an
extension of credit to people who really cannot afford it is
credit counseling. Financial literacy is an enormously
important subject and one that is worthy of a lot of attention
because the lack of financial literacy lies at the heart of
many abusive practices.
Senator Dodd. These numbers, going from 30 percent of all
bankruptcies taken by people in their 20's and 30's, starting
out in life with bankruptcy?
Mr. Hawke. I think that is staggering.
Senator Dodd. And the number is going from 1 to 5 percent.
Isn't that worrisome, if kids under 25, 5 percent of
bankruptcies? I find that jump rather alarming, do not you?
Mr. Hawke. I do, yes.
Ms. Tanoue. Senator Dodd, I would just add some context in
terms of credit cards. Personal bankruptcies obviously have a
direct impact on credit card losses. For the last 2 years,
personal bankruptcies and credit card losses have been trending
downward. But for the first quarter of this year, there
actually is an uptick in personal bankruptcies.
Senator Dodd. Right.
Ms. Tanoue. Possibly in anticipation of some of the tighter
rules that you are talking about. But any weakening in the
economy might be likely to result in more bankruptcies and
thus, rising losses in credit card loans.
I would also like to mention that, in terms of some of the
predatory practices, I can think of at least one very, very
serious case that we are dealing with where a credit card
issuer is engaging in certain types of practices, certain types
of disclosure practices and sales practices, that are very much
on the margin.
And we are looking very hard at what the appropriate
enforcement measures might be with respect to some of the
standards that have been set under the FTC Act and with respect
to regulations currently under the banking regulators'
jurisdiction.
Senator Dodd. Ms. Seidman, do you have something to add?
Ms. Seidman. Well, first of all, I am the mother of a 17
year old, so this is, as with the Comptroller, a very intimate
subject right now. I think that the issue that you have raised
with respect to the standards is interesting and important, and
I want to comment on the third one, which is the credit
counseling standard. I think the Comptroller is right not to
just say, yes, and here is my reason.
As you know, in connection with homeownership for lower
income families, many, many of the institutions and
particularly, Fannie Mae and Freddie Mac, have been requiring
credit counseling to get one of the low downpayment loans.
Last year, Freddie Mac did a study that indicated that a
lot of what is called counseling is completely, totally and
utterly useless. In contrast, some types of counseling,
particularly the kind done one-on-one by the nonprofits, really
do seem to have a real impact.
So, I am a little bit concerned about that third prong.
Without some standards for what you mean by credit counseling,
you are not going to have much of a result.
Senator Dodd. If I dropped the third one, then--
Ms. Seidman. No, no. The problem is you have to improve the
third one, not drop it.
Senator Dodd. It is a choice. You do not have to do all
three. You could have it cosigned by someone else or
demonstrate the ability to pay.
Ms. Seidman. I hear you.
Senator Dodd. That sounds like an outrageous request to me,
that an institution is lending you, in effect, money with a
credit line of $3,000, $4,000, $5,000, $7,000, and you need
nothing but your signature and a student ID. Now, come on. This
is outrageous.
Ms. Seidman. I understand. I also think it is terribly
outrageous that the universities are not only allowing this
situation, but also participating in it. And I think there are
a lot of places where we have to get after this.
Senator Dodd. But I do not hear--it is kind of silent. And
I am looking to you folks to say something. We offer
amendments, but it always helps to have folks who are out there
dealing with these institutions to speak out on this stuff.
Ms. Seidman. Right. And I think we have given you our
opinion. I would just say that that third prong is I think an
issue.
Senator Dodd. I understand that. I thought I was making it
relatively innocuous, in a sense. I am trying to do something
that requires something other than just your signature and
showing an ID to get $5,000 worth of credit.
Ms. Seidman. Longer-term financial literacy training is the
critical piece, to get that into the schools.
Chairman Sarbanes. But this problem is growing. I think the
Fed this morning had some release about the percent of
disposable income now that is constituted in debt service
payments. It is up to 14 percent, as I recall the figure.
Chairman Greenspan. That is correct, Senator.
Chairman Sarbanes. The average credit card debt per
household, the Chicago Sun-Times reported, has grown over
$8,000, three-fold in the past decade.
Senator Dodd. They are kids.
Ms. Seidman. They are kids.
Senator Dodd. And we are looking for some guidance and
help. We went through two bills and I heard nothing from
regulators about the wisdom of putting some brakes on this
thing here.
Ms. Seidman. Senator, let me get back to you on this one.
Chairman Sarbanes. Good.
Senator Schumer.
COMMENTS OF SENATOR CHARLES E. SCHUMER
Senator Schumer. Thank you.
Just one thing I would suggest about this at least to think
about, is the same kind of rule that brokers have--a
suitability rule be implemented for all kinds of loans, the
student loans as well as the mortgages and all of that kind of
thing, which would make some sense without nailing down what
specifically had to be done.
I think a suitability rule works, at least in the
securities industry, and maybe should be applied to loans as
well. And it is something to think about. I would like to
address the first question to Chairman Greenspan.
The question I most get asked, which of course relates to
the health of financial industries, and that is, it seems that
the reed--some would say thin reed. I am not sure that is
right--that our economy is hanging on right now is consumer
confidence, which, with all the buffeting that is gone on, has
stayed at a reasonably decent level.
The question I have, the question that I get asked more
than any other, is, given the fact that layoffs have increased
and accelerated over the last period of time, and people read
about those and worry about those when they reach a certain
level, how in general historically have layoffs affected
consumer confidence? How direct a correlation is there?
And second, does the present acceleration of layoffs or the
recent acceleration of layoffs make one worry about consumer
confidence levels, that even if the economy stayed where it is,
that consumer confidence would decline with those layoffs and
then cause the economy to go down further?
Chairman Greenspan. Senator, most of the major estimates of
consumer confidence, the proxies for actual psychological
consumer confidence, if I can put it that way, employ some sort
of measure of what either is the expected unemployment rate at
some future point or whether you yourself or members of your
family are likely to be laid off. And there is even one
sophisticated one: what is the probability that you will be
laid off ? So, they actually embody that specific notion within
their statistical measure.
There is no question that the issue of layoffs has to be a
factor in determining the propensity of people to spend money
to make a number of commitments which require the maintenance
of an income.
So the answer I would give to you is that, yes, layoffs do
tend to impact on consumer confidence. We have had a
significant pick-up in initial claims on insured unemployment,
which is the broadest measure that we have on layoffs. It is
doubtless impacting to a certain extent on consumer confidence,
at least in the proxies that are effectively employed using
that. But we have not yet seen any serious deterioration in the
actions that people take.
Senator Schumer. Right.
Chairman Greenspan. And what you have to argue is that the
ultimate measure of consumer confidence is not the statistical
calculations we make about proxies of what tends to correspond
to our judgments of consumer confidence, but what do people do?
Senator Schumer. Right.
Chairman Greenspan. So far, they have exhibited a fairly
high degree of confidence. Consumer expenditures have not been
going up in any material way, but they have held their own.
Senator Schumer. The worry is that after month after month
of people reading of these layoffs, worrying about them more in
their own families, the neighbor down the street or whatever,
that it affects the consumer's spending.
Chairman Greenspan. That has been our history, Senator. And
I think it is clearly an issue which we at the Federal Reserve
watch very closely.
Senator Schumer. But so far, we have not seen that--has the
measure of layoffs accelerated over the last 3 months, that we
would not see it yet even if it were going to occur, or has it
been steady over the last 6 or 7 months?
Chairman Greenspan. The rate of layoffs has gone up. In
fact, as I said, the broadest measure we have of layoffs is
initial claims and that, as you know, has gone from under
300,000 a week to in excess of 400,000, so that all of the
measures that we pick up on a weekly basis in those insured
data--insured unemployment data systems--as well as our much
broader employment series, does show a pick-up.
Senator Schumer. I do not know what we can do about it
here, although it relates to another question. But if one were
looking generally at the economy, the level of worry one should
have about consumer spending continuing should increase. It
should be higher today than it was a few months ago.
Chairman Greenspan. I agree with that and I think that is a
correct view. But I think there is an interaction here which is
also very complex.
Senator Schumer. No question. Let me ask you this. Given
the decline in productivity which we have discussed--
Chairman Greenspan. The decline in the rate of growth in
productivity.
Senator Schumer. The rate of growth, although did not it
actually decline in one quarter?
Chairman Greenspan. It went down in the first quarter, but
I would suspect that it will not be continuing in the second
quarter.
Senator Schumer. Given the decline in, at minimum, the rate
of growth of productivity, and I hope you are right.
Chairman Greenspan. I agree with that.
Senator Schumer. Okay. And how important that is to long-
term growth, and this is the question that Evan Bayh asked, but
should we be more worried today about the size of the tax cut,
which I believe at some point you said had an effective rate
higher than--actually would affect the budget higher than the
1.35. I think you used, I read somewhere that you, I think,
said it was closer to $2 trillion in its overall effect, given
interest.
Chairman Greenspan. I do not believe I said that.
Senator Schumer. Strike that. No, I did not read it
directly from you. I read it on a memo that you had said it and
I had not read anywhere where you said it. So strike that.
Chairman Greenspan. Let me just say this. I have never made
such a calculation.
Senator Schumer. Okay. Good. But given the change that we
have seen in the economy over the last several months since the
tax bill was proposed, not since it was signed, do we have
greater worry about our status as a surplus government as
opposed to a deficit government?
Chairman Greenspan. It depends on what happens to the
expenditure side of the budget.
Senator Schumer. Let's say it grows at the rate of
inflation.
Chairman Greenspan. Well, clearly, if you take $1.35
trillion out of the current services surplus, the actual
surplus available for expenditures would be less than the
current services surplus. I mean, that is arithmetic and I
acknowledge that.
Senator Schumer. No, no. But you are not worried at this
point that we are going to, even though the economy is not as
strong as when the initial tax cut was proposed, or even the
$1.35 trillion was arrived at, you are not worried about us
sliding back into deficit spending?
Chairman Greenspan. I am not, Senator.
Senator Schumer. You are more optimistic than I am. One
more to the other two. What do you think of the suitability
rule applying to borrowing, lending, as opposed to investment
in securities? I would ask that of Mr. Hawke.
Mr. Hawke. I think that is an interesting idea, Senator
Schumer. But I am not sure that I would really like to see
bankers making suitability judgments about the extension of
credit beyond the basic kind of credit underwriting standards
that I was talking about.
I think the basic rules of sound credit extension subsume a
suitability test. And that is, can the borrower service and
repay the loan out of current resources without recourse to the
collateral? If the lender makes that kind of judgment, I think
that is basically what we need to assure that credit is not
being pushed out to people who really cannot afford it. If you
go beyond that and try to impose on bankers some judgmental
responsibility for determining the purposes for which the loan
is being taken out or other aspects of suitability of the sort
that a registered broker-dealer might have to make under the
securities laws, I think that raises other issues. But the
basic standards of sound underwriting that have been
traditional in the banking business for years provide a kind of
suitability test, and if they were observed, I think that that
would take us a long way.
Chairman Sarbanes. Senator Carper.
COMMENTS OF SENATOR THOMAS R. CARPER
Senator Carper. Thanks, Mr. Chairman. I apologize for being
late and missing all of your testimony and most of the
questions. We have another hearing going on. The title of this
hearing is the Condition of the U.S. Banking System. There have
been times in the past 10, 20 years we could have said we are
in some kind of crisis. There is another committee hearing
going on today about the energy crisis in California and other
parts of the country. And I apologize for not being here for
this one. That seemed more of a crisis than we face in the
areas that you oversee, so maybe that is good news.
Chairman Greenspan, welcome back. And to our other
panelists, thank you for joining us today. My wife is from
North Carolina. And every Easter, we go down to North Carolina
and we literally camp out in the wilds of North Carolina with
her family, siblings, and their children. We were sitting
around the camp fire back around Easter and heard a chilling
story of identity theft involving the children of one of my
wife's siblings, and how this has plagued her in her life for
much of the last year, actually more than a year.
Someone gave me a note here that said that a publication
called the SAR (Suspicious Activities Reports) Activity Review
reported some very large increase in the amount of reported
identity theft and the impact that it has had on the lives of
literally thousands of Americans. It seems to be a growing
phenomenon. Having talked to someone who has lived through this
for the past year or so, I am just wondering what can you do in
your roles and what can we do in our roles to confront this
growing concern?
Chairman Sarbanes. Let me add to that, The Washington Post
had an article just a few weeks ago--the Justice Department
says that identity theft is one of the Nation's fastest-growing
white collar crimes, just to underscore what Senator Carper is
asking about.
Mr. Hawke. I think that that is a very serious problem,
Senator. We, and I believe the other agencies, just within the
past few weeks, put out--I think it was quite a comprehensive
advisory to banks on the need to have controls in place and to
be alert to occasions when identity theft might be occurring.
If financial institutions apply rigorous rules with respect to
the access to information, it will help immeasurably, I think,
in this regard.
Banking institutions cannot be a complete bulwark of
protection against identity theft because, in some instances,
it is beyond the ability of the bank to control. But they can
be vigilant, and they can be rigorous in the way they verify
the identity of people who are opening accounts. They can
certainly be vigorous in avoiding the disclosure of account
information and other confidential information to people
without very solid identification of the person to whom they
are giving the information.
Senator Carper. Please.
Ms. Tanoue. I would just reiterate that all the agencies,
including the FDIC, have issued guidance on identity theft.
Senator Carper. Is this recent?
Ms. Tanoue. I think during the past 5 months, yes. And that
guidance does include information on measures that institutions
can take to protect against stolen information. We would be
happy to provide you a copy.
Senator Carper. Thank you.
Mr. Chairman.
Chairman Greenspan. Senator, I think that what we are
observing is probably an inevitable consequence of the
tremendous increase in information technology. The very
technology, however, that is creating the availability of a lot
of this information which had not been available before to be
absconded with, is also likely to be where the problem is going
to be solved because we have very rudimentary mechanisms now
for identification--Social Security numbers, driver's licenses,
a variety of things which are so simple essentially to copy.
We are invariably going to much more sophisticated means of
identification. We already have them in a number of areas,
obviously. And my impression is that until we move the
technology into areas where it is very difficult to, for
example, match eye prints or fingerprints or voice prints or a
variety of things which are not simple things to copy, until we
get to those levels, in my judgment, this is going to be an
issue.
I must admit, I was surprised at how fast the issue came
up. And I think we are going to be dealing with it for a while.
But I do think that the very emergence of it is probably going
to put in place a good deal more of quasi-cryptographic means
by which one can identify oneself and that should, hopefully,
make it far more difficult to essentially steal somebody's
identity for purposes of obtaining, usually relatively small
cash awards.
Senator Carper. Thank you for that. We have seen it in our
own family, just from a personal perspective, what it does to
an individual in their life. Obviously, as this threat grows or
this level of criminal activity grows, it poses an increasing
threat to our financial institutions as you well know.
Chairman Greenspan. For example, we had the comparable
issue in counterfeiting. It is not unrelated. We have made very
significant advances in this area and I think much of the same
type of approach is available to protect identities.
Senator Carper. Mr. Chairman, I have one more question, if
I could. And this is a short one. I was Governor when Congress
was debating and adopting and the President was signing into
law the Gramm-Leach-Bliley bill. But a number of folks
predicted coming out of the adoption of that legislation that
its enactment would lead to increased mergers between banks and
insurers. So far, I do not think we have seen a great deal of
that. And I would just like to know your thoughts about why,
and if you expect to begin to see some increased merger
activity that had been predicted.
Chairman Greenspan. I think it is too soon in the sense
that the regulatory structure is not in place, that these are
very major moves on the part of institutions, and we will see
them as time moves on and as we begin to integrate the statute
into regulation and into the history which will enable
individual institutions to make judgments as to whether in fact
the regulatory climate which is available to them is conducive
to an effective merger.
Mr. Hawke. I think there are a couple reasons, Senator. As
I talk to bankers and ask that same question--why there has not
been more interest, for example, in acquiring insurance
underwriters--they basically tell me they are not really very
familiar with that business. It is a strange business to them,
and the returns are quite different from those that bankers are
looking at. And, looking at that from the other end of the
pipeline, the insurance underwriters who presently do not own
depository institutions may have some reservations about
subjecting themselves to the regulatory environment that would
be required.
In the securities area, banks, as a result of rulings that
the Federal Reserve made a number of years ago, have already
been able to expand very significantly into a whole variety of
securities activities. And again, looking at that from the
other end of the pipeline, you have something of the same
thing. Securities firms may not be acquiring depository
institutions because of concerns about taking on another type
of regulation that they are not presently subject to.
The one area in which I think Gramm-Leach-Bliley has been
particularly useful and successful is in expanding the
opportunities for banks, large and small, all over the country
to increse their insurance sales activities. If you talk to
community bankers, that is one thing that they latch onto that
was really important to them in Gramm-Leach-Bliley.
Senator Carper. All right. Thank you all very, very much.
Mr. Chairman, thank you.
Chairman Sarbanes. Thank you very much, Senator Carper. I
have a few questions that I want to ask as we draw toward a
close. And of course, Senator Corzine has been here. He may
want another round as well.
First of all, Senator Corzine and I have both been very
interested in this financial literacy and education issue.
Actually, Chairman Greenspan, you gave a major speech on that.
I think it would be helpful to us if we could get from each of
the agencies, and this following a bit up on Senator Dodd as
well, your view of how much of a need there is, how much of a
shortfall there is with respect to financial literacy and
education and what might be done about it. Both in a broader
sense and even what your agencies might do in order to counter
a problem of a lack of financial literacy and education, if in
fact you perceive there to be one. I take it that most of you
do. Would I be safe in saying that?
Mr. Hawke. Mr. Chairman, I would say that basic financial
literacy is certainly a concern. One element of that is the
persistent resistance of many people to deal with commercial
banks. This may not be an issue of financial literacy so much
as something that is more sociological. But we see again and
again in survey data that people are unwilling to deal with
commercial banks for one reason or another. So, they use check
cashers and fringe providers, payday lenders that are much more
high-priced and do not have the ability to provide the same
range of services. People will walk by a commercial bank to go
to a payday lender right next door. One aspect of financial
literacy that I think is very important is educating people and
educating banks about how they can do a better job in reaching
them.
Chairman Sarbanes. We worked with Secretary Summers on that
because he was quite interested in that issue and actually
undertook some initiatives when he was Treasury Secretary in
order to try to bank the unbanked, so to speak, or draw them
into the financial mainstream. And they developed a number of
programs at Treasury in order to try to do that. We are not
certain yet whether this Treasury is going to continue down
that path and seek to carry that through, but I think that is
very important. All four of your agencies recently joined in
issuing an advisory--I have the impression that the four
agencies are working together in a more coordinated fashion
than used to be the case. Is that an accurate impression or was
it always the case?
Chairman Greenspan. No, it is been up and down, Mr.
Chairman. I think we are in an up stage at this point. But even
on the down side, it works well in the sense that the
alternative, which is basically to have a monopoly regulator, I
do not think would serve this country well. So there are
problems in the sense--I think Ellen Seidman mentioned it--we
do not come to agreements immediately. We do not come to
conclusions as quickly as some would like. So that there is
friction and there is cost and there is probably excess
conversation that goes on.
But having said that, I think it is a very small price to
pay for what is an extraordinarily effective regulatory system
in this country. And it is encumbent upon all four of us to
make certain we endeavor to find a center we can coalesce
around. The goodwill in the process has been really quite
measurable and I think quite effective.
Chairman Sarbanes. Well, you issued this advisory:
High on or off balance sheet growth rates are a potential
red flag that may indicate the need to take action to ensure
the risks associated with brokered or other rate-sensitive
funding sources are managed appropriately.
How serious is the problem. What actions are you taking, if
any, other than issuing the advisory?
Ms. Tanoue. This relates to the funding and liquidity
issues that I think we have all testified about. We are working
very closely to issue guidance like that through the FFIEC.
In addition, we are watching the credit portfolios of the
institutions very closely as they try to meet these funding and
liquidity challenges.
Mr. Hawke. Liquidity is a subject that we talk about with
our banks all the time. We recently had a telephone seminar
devoted entirely to liquidity. We had hundreds of banks around
the country signed up, and it gave us the opportunity to
address directly many of these concerns about liquidity.
Chairman Sarbanes. I want to follow up on a question that
Senator Bayh asked. And that is, we may look at our own system
and say, well, it is in pretty good shape and it is pretty
strong. But how severe is the risk to which we are exposed from
a breakdown in the systems overseas? Japan has very serious
problems right now from all reports. We had an Argentina scare.
How exposed are we in this kind of world economy so that we
must also have at the forefront of our worries the world
context in which we are operating, no matter how much we may
look at our own system here and say it is in pretty good shape.
Something happens overseas, and the next thing we know, we have
a major problem on our hands.
Chairman Greenspan. Mr. Chairman, we are very conscious of
that. And indeed, more importantly, so are the banks because a
goodly part of their risk-management systems focus on
addressing precisely the types of risks which you allude to.
That is not to say that you can eliminate these problems very
readily because, obviously, you are not only dealing with
credit risk and the other risks we see domestically, but, very
often you are dealing with exchange rate risk as well. And so,
there are lots of possibilities for difficulties to emerge.
There are lots of threats to the capital of the banking system
as a consequence.
But that is precisely what risk-management is all about.
And what we endeavor to do in overseeing a number of our
institutions, is to try to understand how they are addressing
precisely this question. I am not saying that we can say with a
great deal of certainty that we are perfectly secure. I do not
think we can ever be secure. Indeed, banking is by its very
nature risk-taking. But I do think we are acutely aware of the
types of problems that can emerge, especially having been
through the East Asian crises of 1997 and the Russian default
shortly thereafter. So that there is not a long history behind
us of tranquility in the international financial system. I
hesitate to say that it is in complete control. It never will
be. But I know of nothing which suggests to me that there is
not a very significant amount of effort involved in both the
banking system and in our supervisory system to make sure as
best we can that these areas are covered.
Chairman Sarbanes. Senator Corzine.
Senator Corzine. Just an observation, I guess, as much as a
question. But I would love your comments back. We talked mostly
about sort of the macroelements of the condition of the banking
system today. We got off here in the latter stages on financial
literacy, which is one of those issues that impacts the overall
soundness of the system--predatory lending, community
development lending, money-laundering, the privacy issues that
Senator Carper talked about.
All of those issues tended not to be where you focused your
testimony, but are issues and conditions. I wonder if there are
things off of my list that I have left out. I would love to
hear how all of you feel we are dealing with the issue, for
instance, of money-laundering, which hasn't been talked about,
which is a serious concern. I think some of the others we
talked at least a little bit about-- community development
lending, whether there is enough attention to that and whether
you think there is a commitment in the private sector to
addressing these sort of microissues as opposed to the
macrorisk-management issues that have been major focus of the
condition of the banking system. And I would ask any of you.
Chairman Greenspan. Let me just start off, Senator, and
say, the fact that you did not hear very much in our prepared
remarks is indicative of the fact that we do not believe that
those microissues are creating major safety and soundness
problems with the commercial banks, which is important in and
of itself. They are all very critical issues which all four of
us spend perhaps almost an inordinate amount of time focusing
on because they are quite difficult to deal with and difficult
to come to the right conclusions on. None of them is simple.
And in fact if they were, they probably wouldn't be problems.
Jerry.
Mr. Hawke. I would concur with that. Money-laundering is
obviously a tremendously important issue. Money-laundering lies
at the heart of drug trafficking. We have very strong
regulations in place that require banks to have systems and
controls that are aimed at identifying instances of money-
laundering.
I think our people have done a very good job in alerting
banks to the risks that are presented in that respect. These
are not only broad risks that relate to drug trafficking, but,
risks that relate to the banks themselves. So banks have a
strong interest in assuring that they are not unwittingly
implicated in other people's illegal conduct, and that is
something we bear down quite heavily on.
Ms. Tanoue. I would also add that within the time
constraints, we only have a certain amount of space in our
testimony and time to address the issues. Some of the issues
that we are also addressing include the CRA regulatory review,
for example, and I think the Committee would be interested
probably in an update at some point soon in the status of that
work.
Senator Corzine. I am sorry?
Ms. Tanoue. The CRA.
Senator Corzine. The CRA, community development.
Ms. Tanoue. Mr. Chairman, I did want to follow up on the
question you had regarding financial literacy. I would mention
that the FDIC has undertaken a very significant nationwide
program on that front, called ``Money Smart,'' in conjunction
with the Department of Labor, to offer education on financial
programs to people outside the mainstream.
Chairman Sarbanes. Can you submit us materials about that?
Ms. Tanoue. Absolutely.
Chairman Sarbanes. We would be very happy to have that.
Senator Corzine. Thank you.
Chairman Sarbanes. All right. Let me say it is my intention
that at some point this year, the Committee will turn its
attention to the money-laundering issue, which is a very
important issue.
Senator Carper, do you have anything else?
Senator Carper. No. Thank you, Mr. Chairman.
Chairman Sarbanes. Well, this has been a very good panel.
We are most appreciative to you. Let me again underscore the
fact that the written statements have obviously been prepared
with a great deal of care and work and we appreciate having
that, as well as your presence here today before us.
Chairman Greenspan, we will be seeing you again next month
when we do the monetary policy hearing and, as always, we look
forward to that occasion.
And we thank all of you for this contribution. We will
continue to maintain this close relationship as we concern
ourselves with the safety and soundness of our financial
system.
Thank you all very much.
The hearing is adjourned.
[Whereupon, at 12:40 p.m., the hearing was adjourned.]
[Prepared statements, response to written questions, and
additional materials supplied for the record follow:]
PREPARED STATEMENT OF SENATOR PAUL S. SARBANES
I am pleased to welcome this distinguished panel of witnesses
before the Banking Committee this morning: Alan Greenspan, Chairman,
Federal Reserve Board; Jerry Hawke, Comptroller of the Currency; Ellen
Seidman, Director, Office of Thrift Supervision; and Donna Tanoue,
Chair, FDIC.
The purpose of today's hearing is to review the condition of the
banking system of the United States. This hearing is not prompted by
any triggering event or problem. Rather, the intention is to return to
a prior practice of this Committee of holding periodic oversight
hearings on the state of the banking system. By making this a regular
event we would hope to elevate scrutiny of the system when times appear
good and there may be a tendency toward complacency, as well as to
defuse potential alarm when a hearing is held at a time that problems
may exist. We would hope the regular scheduling of this hearing would
be a useful discipline on the system and perhaps itself serve as a
stabilizing influence.
It appears that the past decade of economic growth has
significantly strengthened the condition of the U.S. banking system. In
my view the enactment by Congress of the Financial Institutions Reform,
Recovery, and Enforcement Act (FIRREA) of 1989 in response to the
thrift crisis, and the Federal Deposit Insurance Corporation
Improvement Act (FDICIA) of 1991 in response to the commercial banking
problems of the late 1980's and early 1990's, contributed to that
improved condition. The capital and regulatory standards put in place
by those statutes helped the system to take advantage of the growing
economy of the 1990's. Improved coordination of supervision by the
regulators also made a contribution.
This morning we will hear from the regulators that the banking
industry is better situated today to withstand a softening of the
economy than it has been in the past. Banks have a greater variety of
products and more geographic diversification in their assets. They have
higher earnings, more capital, better risk-management techniques, and
higher asset quality than in the past.
Nevertheless they will also point out that asset quality problems
have worsened for the past 2 years and loan loss provisions have
increased substantially. Non-interest income of banks has been affected
by a less robust economy and weaker stock market. Net interest margins
declined for the sixth consecutive quarter to their
lowest level since the first quarter of 1987. Loan losses continued to
rise, with commercial and industrial loans accounting for more than
half of the increase. The deterioration was concentrated among larger
banks.
The manufacturing sector has also been slowing down, which affects
commercial loan quality. Increasing numbers of employees are being laid
off, which is adversely affecting the quality of consumer loans.
Sectors such as telecommunications, technology, and agriculture, and
the banks that service them, are facing serious economic challenges.
And consumers are more highly leveraged today than at any other
measured point.
The Committee will want to review all of these issues with the
regulators this morning. Most fundamentally we will want to get an
assessment from the regulators not only of how the system looks today,
but how it may look 6 months or a year from now. The consensus forecast
is that economic growth will pick up in the third and fourth quarters
of this year and resume at a faster pace next year. If that is true, it
will obviously have a beneficial impact on the banking system.
However, that outcome is far from assured. If the economy remains
weak for the rest of this year, what impact will that have on the
banking system? How well equipped is the system to cope with a weak
economy as well as a growing economy? These are some of the threshold
questions we will want to explore with the bank regulators today. I
look forward to hearing their testimony.
----------
PREPARED STATEMENT OF ALAN GREENSPAN
Chairman, Board of Governors of the Federal Reserve System
June 20, 2001
Mr. Chairman and Members of the Committee, I am pleased to be here
this morning to discuss the condition of the U.S. banking system. In my
presentation today, I would like to raise just a few issues. I have
attached an appendix in which the Federal Reserve Board staff provides
far more detail relevant to the purpose of these hearings.
There are, I believe, two salient points to be made about the
current state of the banking system. First, many of the traditional
quantitative and qualitative indicators suggest that bank asset quality
is deteriorating and that supervisors therefore need to be more
sensitive to problems at individual banks, both currently and in the
months ahead. Some of the credits that were made in earlier periods of
optimism--especially syndicated loans--are now under pressure and
scrutiny. The softening economy and/or special circumstances have
especially affected borrowers in the retail, manufacturing, health
care, and telecommunications industries. California utilities, as you
know, have also been under particular pressure. All of these, and no
doubt other problem areas that are not now foreseeable, require that
both bank management and supervisors remain particularly alert to
developments.
Second, we are fortunate that our banking system entered this
period of weak economic performance in a strong position. After
rebuilding capital and liquidity in the early 1990's, followed by
several years of post-World War II record profits and very strong loan
growth, our banks now have prudent capital and reserve positions. In
addition, asset quality was quite good by historical standards before
the deterioration began. Moreover, in the last decade, as I will
discuss more fully in a moment, banks have improved their risk-
management and control systems, which we believe may have both
strengthened the resultant asset quality and shortened banks' response
time to changing economic events. This potential for an improved
reaction to cyclical weakness, and better risk-management, is being
tested by the events of recent quarters and may well be tested further
in coming quarters.
We can generalize from these recent events to understand a bit
better some relevant patterns in banking, patterns that appear to be
changing for the better. The recent weakening in loan quality bears
some characteristics typical of traditional relationships of loans to
the business cycle. The rapid increase in loans, though typical of a
normal expansion of the economy, was unusual in that it was associated
with more than a decade of uninterrupted economic growth. As our
economy expanded, business and household financing needs increased and
projections of future outcomes turned increasingly optimistic. In such
a context, the loan officers whose experience counsels that the vast
majority of bad loans are made in the latter stages of a business
expansion, have had the choice of restraining lending, and presumably
losing market share or hoping for repayment of new loans before
conditions turn adverse. Given the limited ability to foresee turning
points, the competitive pressures led, as has usually been the case, to
a deterioration of underlying loan quality as the peak in the economy
approached.
Supervisors have had comparable problems. In a rising economy
buffeted by competitive banking markets, it is difficult to evaluate
the embedded risks in new loans or to be sure that adequate capital is
being held. Even if correctly diagnosed, making that supervisory case
to bank management can be difficult because, regrettably, incentives
for loan officers and managers traditionally have rewarded loan growth,
market share, and the profits that derive from booking interest income
with, in retrospect, inadequate provisions for possible default.
Moreover, credit-risk specialists at banks historically have had
difficulty making their case about risk because of their inability to
measure and quantify it. At the same time, with debt service current
and market risk premiums cyclically low, coupled with the same
inability to quantify and measure risk, supervisory criticisms of
standards traditionally have been difficult to justify.
When the economy begins to slow and the quality of booked loans
deteriorates, as in the current cycle, loan standards belatedly
tighten. New loan applications that earlier would have been judged
creditworthy, especially since the applications are now being based on
a more cautious economic outlook, are nonetheless rejected, when in
retrospect it will doubtless be those loans that would have been the
most profitable to the bank.
Such policies are demonstrably not in the best interests of banks'
shareholders or the economy. They lead to an unnecessary degree of
cyclical volatility in earnings and, as such, to a reduced long-term
capitalized value of the bank. More importantly, such policies
contribute to increased economic instability.
The last few years have had some of the traditional characteristics
I have just described: the substantial easing of terms as the economy
improved, the rapid expansion of the loan book, the deterioration of
loan quality as the economy slowed, and the cumulative tightening of
loan standards.
But this interval has had some interesting characteristics not
observed in earlier expansions. First, in the mid-1990's, examiners
began to focus on banks' risk-management systems and processes; at the
same time, supervisors' observations about softening loan standards
came both unusually early in the expansion and were taken more
seriously than had often been the case. The turmoil in financial
markets in 1998, associated with both the East Asian crisis and the
Russian default, also focused bankers' attention on loan quality during
the continued expansion in this country. And there was a further
induced tightening of standards last year in response to early
indications of deteriorating loan quality, months before aggregate
growth slowed.
All of this might have been the result of idiosyncratic events from
which generalizations should not be made. Perhaps. But at the same time
another, more profound development of critical importance had begun,
the creation at the larger, more sophisticated banks of an operational
loan process with a more or less formal procedure for recognizing,
pricing, and managing risk. In these emerging systems, loans are
classified by risk, internal profit centers are charged for equity
allocations by risk category, and risk adjustments are explicitly made.
In short, the formal measurement and quantification of risk has
begun to occur and to be integrated into the loan-making process. This
is a sea change--or at least the beginning of one. Formal risk-
management systems are designed to reduce the potential for the
unintended acceptance of risk and hence should reduce the procyclical
behavior that has characterized banking history. But, again, the
process has just begun.
The Federal banking agencies are trying to generalize and
institutionalize this process in the current efforts to reform the
Basel Capital Accord. When operational, near the middle of this decade,
the revised accord, Basel II, promises to promote not only better risk-
management over a wider group of banks but also less-intrusive
supervision once the risk-management system is validated. It also
promises less variability in loan policies over the cycle because of
both bank and supervisory focus on formal techniques for managing risk.
In recent years, we have incorporated innovative ideas and
accommodated significant change in banking and supervision.
Institutions have more ways than ever to compete in providing financial
services. Financial innovation has improved the measurement and
management of risk and holds substantial promise for much greater gains
ahead.
Building on bank practice, we are in the process of improving both
lending and supervisory policies that we trust will foster better risk-
management; but these policies could also reduce the procyclical
pattern of easing and tightening of bank lending and accordingly
increase bank shareholder values and economic stability. It is not an
easy road, but it seems that we are well along it.
Appendix: Condition of the Banking Industry
Prepared by: Staff, Board of Governors of the Federal Reserve System
June 20, 2001
The U.S. banking industry is well capitalized and highly profitable
by historical standards and in reasonably good shape, although there
are signs of erosion as problem loans have risen, especially in larger
syndicated credits. Moreover, some further erosion is likely as
borrowers who have taken on heavy debt burdens experience less robust
increases in profits and income than might have been anticipated not
too long ago. In many cases, problem loans are a hangover from loans
made in the mid-1990's when lenders evidently failed to exercise
sufficient discipline. After about 1998, banks took a number of steps
to tighten lending standards and terms, which should help to limit
further deterioration. Nevertheless, with a weakening economy, problems
could well worsen for some banks and some market segments, requiring
vigilance by banks and their regulators. As always, the underlying
issue is how to adopt and price realistic assessments of likely credit
risks under alternative scenarios, keeping credit flowing to worthy
borrowers at reasonable prices.
Today, banking organizations and their supervisors are taking a
number of steps that will be necessary to ensure that our financial
system continues to flourish and support long-term economic growth well
into the future. Key elements of such actions are referenced in the
last two sections of this appendix.
Earnings
Although banking profitability has risen to historically high
levels in terms of return on assets and return on equity over the past
decade, in recent periods higher loan loss provision expenses and
narrowing net interest margins have placed pressures on bank
profitability. Despite those emerging weaknesses, downside risks likely
have been limited by the increasing diversity of noninterest and
interest sources of revenues. The continued push by banks to diversify
their revenues by expanding business lines devoted to asset management,
servicing, securitization, investment banking, and other fee-based
activities should help stabilize earnings streams. In addition, in the
wake of consolidation and interstate banking, many larger firms are
less vulnerable to downturns in particular regions or specialized
business lines.
Nonetheless, in the past few quarters, emerging earnings weaknesses
have been pronounced at some of the larger banking organizations, which
have experienced sharp increases in loan loss provision expenses,
narrowing interest margins, and significant declines in venture capital
revenues. During the first quarter of this year, those negative
developments at large firms were somewhat offset by record trading
profits and better overhead cost efficiency. While the net effect was a
decline in profits at many larger banking organizations, the underlying
strength in the profitability of regional and community banks, coupled
with nonrecurring securities gains, helped the industry as a whole
achieve record first quarter earnings of nearly $20 billion.
Asset Quality
The rise in nonperforming assets at banking organizations has been
pronounced over the past year, especially at larger banking
organizations. Despite that rise, these problems generally remain
moderate in historical terms relative to earnings, assets and capital.
Assets classified as substandard, doubtful or loss have also risen
rapidly in recent periods, though again from a modest base. Much of
that increase is attributable to larger syndicated credits, though
there are some indications of softening in the credit quality of
middle-market borrowers. In response to this rise, banks have written
down assets to estimated net realizable values and replenished reserves
for expected problems through loan loss provision expenses.
A common theme for many of the problem credits has been significant
leverage employed to expand businesses during times of ebullient
economic and market conditions. Many of these credits were originated
during a period of relaxed lending standards that did not adequately
account for the susceptibility of the borrower to weakening sectoral or
economic conditions. After the reminders in 1998 from the Asian
disruptions and the Russian default, lending standards were tightened.
But, with the advent of a softening economy, the embedded risks of
weaker or more vulnerable borrowers are becoming well recognized.
Particularly hard hit have been certain borrowers in the retail,
manufacturing, health care and telecommunications industries. In
addition, unexpected developments in asbestos litigation as well as the
difficulties faced by the California utilities have also added
considerably to the stock of classifications.
The rapid deterioration of credit quality in certain segments of
bank loan portfolios reflects the significant share of the growth in
bank lending in recent years to borrowers on the borderline between
investment and noninvestment grade creditworthiness. With the presence
of active money and capital markets in the United States, and their
ease of access by the best quality borrowers, these credit grades
reflect the quality of those with which our banks now normally deal.
They represent the types of borrowers that tend to require the more
customized analysis, underwriting and structuring offered by banks that
may not be as readily available or as cost-effective through the bond
market. The higher magnitude and volatility of default rates in these
types of borrowers is well documented from decades of experience in the
below-investment grade segment of the bond market. Consequently, as
conditions have weakened and defaults have risen sharply in
noninvestment grade bonds, a parallel increase has occurred in troubled
and nonperforming loans of bank portfolios. Forecasts for a continued
rise in defaults for lower rated bonds by Moody's suggest that bank
corporate asset quality is also likely to deteriorate further before it
improves.
Although part of the deterioration may be a natural consequence of
taking normal business risk in a weaker economy, part also reflects a
lack of discipline by some banks, particularly in the 1995-1997
interval. As banking organizations relaxed their standards and the
rigor of their credit risk analysis in this period, banking supervisors
responded by issuing cautionary guidance and stepped up the intensity
of reviews of lending operations at many banking firms. In particular,
supervisors pointed out the need for lenders to avoid the use of overly
optimistic assumptions that presumed strong conditions would prevail
indefinitely. In addition, supervisors also noted the lack of downside
risk analysis or stress testing as a weakness in risk-management
practices at many banks.
Recent credit losses have highlighted the importance of following
those sound lending and evaluation fundamentals and have clearly
differentiated strong credit risk-management systems from weak ones,
prompting many organizations to take remedial action. For the past
several years, the banking agencies have shifted their supervisory
approach to focus on risk-management processes at banking organizations
as a more effective means for promoting sound banking practices. While
bank risk-management practices have improved, in part because of
supervisory efforts, recent experience has shown that more work needs
to be done. More recently, to help facilitate improvements underway at
banks in response to current credit difficulties, the banking agencies
issued guidance earlier this year clarifying their expectations
regarding sound practices for managing leveraged finance exposures.
Even before recent weaknesses, banks had begun to reevaluate their
strategic direction and, with the encouragement of supervisors, had
become more deliberate about the need to implement formal procedures
for recognizing, pricing, and managing risk. Without these reforms, the
recent deteriorating trends would likely have been considerably worse.
In these emerging systems, loans are classified by risk, internal
profit centers are charged for equity allocations by risk category, and
risk adjustments are explicitly made. In addition, more advanced
systems provide the metrics that are necessary to support active
portfolio management, including decisions on whether certain loans
exhibiting emerging weaknesses should be sold and at what price. The
active sale of troubled syndicated credits has been an emerging trend
among larger organizations. In particular, the increasing appetite for
these loans by nonbank investors has helped deepen and liquefy the
market, providing an outlet for banks with adequate capital and
reserves to sell loans at a discount to par value and to rebalance
their portfolios.
Today risk-management systems have also helped rationalize the
pricing of risk through stricter terms and conditions for more
vulnerable borrowers. Sophisticated risk-management systems are also
helping banks to reevaluate the profitability of bank lending by
benchmarking loans against corporate hurdle rates. In many
circumstances, banks are recognizing that without the ancillary cash
management or other revenue opportunities attached to the lending
relationship, it is difficult to find stand-alone lending opportunities
that meet these hurdle rates. By using these sophisticated quantitative
risk-management tools to support their decisionmaking, banks are better
able to distinguish profitable versus unprofitable relationships and
determine if a particular customer is compatible with the bank's
appetite for risk.
At present, the tightening of terms and standards at banks and the
bond market has not inhibited the flow of funding to sound borrowers,
though borrowers appear to be increasingly tapping the bond market, and
lenders and the bond market also are requiring higher spreads for
marginal credits. While tightening can be over done, so far banks seem
to be making balanced decisions on the tradeoff between risk and
returns. This is a favorable outcome, because it assists in directing
capital flows to their highest and best use in the economy.
Much focus has been placed on the dynamics within the corporate
loan book, which is currently experiencing the majority of problems,
but banks and supervisors should continue to be vigilant for other
potential risks. In particular, though retail credit quality has been
fairly stable in recent years, consumers, like corporations, have also
increased leverage, making their ability to perform under stressful
circumstances less reliable. In recent years, buoyant economic
conditions raised expectations for continued growth in income and
employment for consumers, which along with rising levels of wealth, has
led to growth in household debt that has outstripped growth in
disposable personal income over the past 5 years. That expansion of
debt has pushed consumer debt service burdens to new highs.
With the recent slowdown in the economy, rising personal
bankruptcies, an increasing unemployment rate, and a modest
deterioration in loan quality, lenders have tempered their outlook,
tightening their standards somewhat for credit cards and installment
loans. At the same time, while consumer spending has leveled as the
economy has weakened, demand for credit has strengthened in recent
periods.
Over the past decade, banking organizations have taken advantage of
scoring models and other techniques for efficiently advancing credit to
a broader spectrum of consumers and small businesses than ever before.
In doing so, they have made credit available to segments of borrowers
that are more highly leveraged and that have less experience in
managing their finances through difficult periods. For the most part,
banks appear to have tailored their pricing and underwriting practices
to various segments of their consumer portfolios to account for the
unique risks related to each. Some institutions have also tailored
lending toward segments with troubled credit histories, the so-called
subprime market. Such lending can be favorable both to borrowers and
lenders. Subprime borrowers benefit by gaining access to credit and the
opportunity to build a sound credit history that may eventually allow
them to achieve prime status. For lenders, subprime lending affords the
opportunity for higher returns provided the necessary infrastructure is
in place to closely track and monitor the risk related to individual
borrowers, which can be labor intensive and costly. Lenders must also
recognize the additional capital and reserve needs to support such
lending, particularly if they have concentrations in subprime loans.
Banks that have not understood the subprime market have had
significant difficulties. To ensure that banks entering this business
properly understand these risks, the agencies have encouraged banks to
adopt strong risk-management systems tailored to the challenges posed
by these loan segments. Beyond poor risk-management, there have also
been instances in which certain lenders have charged fees and
structured loans designed not to protect against risk, but rather to
deceptively extract a borrower's net worth. Such predatory lending
practices, though rare, are a cause for concern and examiners are
watchful for programs that would violate the law in this regard.
Another area of supervisory focus, of course, is commercial real
estate. The exceptional demand for office and other commercial real
estate in recent years has led to a rebound in the volumes of loans
secured by these properties. This time, however, as demand has grown,
larger banking organizations have managed to keep their holdings modest
relative to their asset bases either through securitizations, sales or
by avoiding originations altogether. In contrast, many smaller
commercial banks have raised their commercial real estate
concentrations relative to assets and capital. While underwriting
practices appear to be much healthier today than they were in the
1980's and standards have tightened somewhat recently, supervisors are
paying particular attention to community banks with concentrations that
make them materially vulnerable to a downturn in this market.
While for the past several years there have been few real estate
markets with material imbalances in supply and demand, emerging signs
of weakness make the need for vigilance more pressing. In the first
quarter of this year, there has been a pronounced increase in
nationwide vacancies that has resulted in a negative net absorption of
office space in the United States. That poor performance, the worst in
20 years, has been attributed by some market observers to the abrupt
return of office space to the market by technology firms and to delays
by prospective tenants hoping that softening conditions will lower
rents further. In this environment, noncurrent commercial real estate
loans have edged up somewhat in the first quarter. Whether the first
quarter represents a temporary phenomenon or the beginning of a longer
term trend remains to be seen, but the need for institutions to
continue a realistic assessment of conditions and stress test their
portfolios is paramount.
In addition to real estate, agricultural lending is also facing
challenges. Commodity price weakness, coupled with changes in the
Federal price support programs, has placed pressures on the ability of
farmers to service their debt. This in turn has led to a rise in
noncurrent farm loans. Banks are continuing to identify ways to work
with their borrowers to navigate through this difficult period.
Funding
For banks to remain in sound condition, they must not only pay
attention to the quality of their assets, but also to the nature and
quality of their funding. In recent years, large and small banks alike
have come to rely increasingly on large wholesale deposits and
nontraditional sources of funds. They have done so in part as the
demand for loans and their own growth objectives have outstripped the
growth in insured core deposits. It is true that retail core deposit
growth has been quite meager over the past decade with higher returns
in mutual funds and the stock market luring customers away from banking
deposits. On the other hand, banks have also made the calculated
decision to pay relatively low-interest rates on some types of retail
accounts and rely on higher-priced jumbo deposits or wholesale
borrowing to fund incremental asset growth.
Despite competition for household funds, community banks have been
relatively successful at maintaining their core deposit bases. For
example, a decade ago banks with less than $50 million in assets funded
around 80 percent of their assets with core deposits. Over the course
of the past decade, that figure eroded by 7 percentage points, but
remains a fairly strong 73 percent of assets. That compares to core
deposit holdings of only 39 percent for banks with more than $10
billion in assets.
While community banks have experienced moderate erosion in the
share of core deposits funding assets, when that trend is coupled with
rapid loan growth, pressures on bank liquidity have intensified. To
replace core deposits, community banks have been fairly successful at
attracting jumbo deposits and have made use of Federal Home Loan Bank
advances. Community banks have also funded the gap between loan and
deposit growth by liquidating securities holdings and accordingly
raising the quantity of loans relative to assets. The combined deposit
and loan trends have pushed liquidity benchmark ratios such as loans-
to-deposits to historic peaks. On the other hand, there are some signs
of relief for bank liquidity. For one, the demand for loans by
businesses and consumers appears to be moderating, and there are some
early indications that consumers are returning to bank retail deposits
in the wake of disappointing stock and mutual fund results.
Still, many of these liquidity pressures are likely to remain in
one form or in another, and banks are likely to continue to explore
nondeposit alternatives for managing their balance sheets. While the
use of nondeposit liabilities to fund growth is not new to banks, the
growing volume, variety and complexity of these funds creates new
issues. To meet this challenge, banks must strive to fully understand
the implication of relying on these types of funds both from a
liquidity and earnings perspective. The Federal Reserve recently issued
guidance on the use of complex wholesale borrowings and the banking
agencies recently issued guidance on rate sensitive deposits to
highlight the importance of adequate management techniques for ensuring
stable and consistent funding.
Capital and Supervisory Initiatives
The most stable funding source for bank balance sheets is
shareholder equity. More significantly, shareholder equity's key
feature is its ability to absorb losses. The need for banks to hold
capital commensurate with the risk they undertake is highlighted by
recent weaknesses in bank asset quality and the uncertain economic
environment. Today, by virtue of market pressures following the
difficulties of the late 1980's, minimum regulatory capital
requirements and the ability of many banking organizations to measure
and recognize their own needs for a cushion against more difficult
times, the industry capital base appears adequate to meet emerging
challenges. From a regulatory capital perspective, the vast majority of
all banks meet the definition for well capitalized.
The original Basel Accord that was adopted in 1988 has served
supervisors and the industry fairly well over the past decade as one of
the primary tools for maintaining a sound banking system. More
recently, the nature and complexity of risk undertaken by many larger
organizations have made the blunt traditional measures of capital
adequacy, whether equity-to-assets, leverage, or current risk-based
capital ratios, less meaningful. In considering the likely continuation
of innovations over the next decade, supervisors must develop ways to
improve their tools while reinforcing incentives for sound risk-
management.
The new Basel risk-based proposal seeks to achieve the twin
objectives of a more meaningful capital adequacy measure and promoting
sound risk-management practices. The proposal by the Basel Committee
that was announced in January of this year calls for an international
capital accord that is based on three pillars: a minimum capital
requirement that is more sensitive to risk, a supervisory review
process, and market discipline. It is important to note that the Basel
Committee is in the process of reviewing the public's comments on the
proposal and there are still a myriad of important issues and details
to address and work out before it can be implemented.
The proposal offers a menu of alternative frameworks for
establishing minimum capital requirements so that institutions can be
matched with the approach that fits their particular degree of
sophistication, risk profile and risk-management capabilities. On one
end of the spectrum, the proposed advanced approach, designed for the
most sophisticated and complex entities, relies on a bank's internal
risk rating and loss estimates in the establishment of the minimum
requirements for credit exposures. At the other end of the spectrum,
the proposed standardized approach modifies the current framework to be
somewhat more risk sensitive but retains many of the simple features of
the current accord.
The second pillar, the supervisory review process, requires
supervisors to ensure that each bank has sound risk-management
processes in place. The emphasis in that review is both on the
integrity of the process that produces the metrics used in calculating
the supervisory minimum, as well as the adequacy of a bank's own
analysis of its capital needs.
The second pillar fits very well with the Federal Reserve's efforts
in recent years to encourage larger, more complex banks to improve
their internal risk rating systems while placing more emphasis on their
own internal analysis of capital adequacy. The new accord is much more
than an effort to improve the meaningfulness of minimum regulatory
capital ratios, although that clearly is an important aspect of the
proposal. Embodied in the proposal are some important risk-management
principles and sound practices that supervisors would expect all of the
very largest and most complex U.S. banks to be following or aspiring
to, even those not electing to use one of the more advanced approaches.
As proposed, the capital standards should provide banking organizations
in the United States and abroad with strong incentives to accelerate
their development and implementation of improved risk-management
systems in order to qualify for a more risk sensitive regulatory
capital treatment. Moreover, the review necessary to ensure that bank
risk measures are sound maintains the focus of supervisors on the key
elements of control and risk-management that govern safe and sound
banking.
The third pillar complements the first two by bolstering market
discipline through enhanced disclosures by banks. By their very nature,
many banking risks are opaque. However, innovations in recent years
that have helped improve the management of risk have also led to the
development of various summary statistics to meaningfully describe
risks that were qualitatively described in the past. While challenges
remain in making such measures comparable or differences across
institutions well understood, such disclosures are a necessary
complement to the other two pillars for the overall approach to retain
the necessary level of rigor and integrity. Disclosure of information
that helps stakeholders determine risk profiles is designed, of course,
to increase, when necessary, the market pressure and costs on bank
lenders that they would otherwise receive as a matter of course if they
were not beneficiaries of the safety net. Market discipline can also
provide useful signals to supervisors.
Significantly, the opportunity for enhanced market discipline
through disclosure is substantial given that larger organizations fund
about two thirds of their assets with uninsured funds. However,
supplemental information will be irrelevant unless uninsured creditors
believe that they are, in fact, at risk. Uninsured creditors have
little reason to engage in risk analysis, let alone act on such
analysis, if they believe that they will always be made whole under a
de facto too-big-to-fail policy. Recognizing that dilemma, in 1991 the
Congress placed in the Federal Deposit Insurance Corporation
Improvement Act a requirement for a least-cost resolution of financial
institutions. Although an exception clause exists, it does not require
that all uninsured creditors be made whole. Conceptually, there are
rare situations where events may require that the FDIC and other
governmental resources be used temporarily to sustain a failing
institution pending its managed liquidation. But indefinitely propping
up insolvent intermediaries is the road to stagnation and substantial
resource misallocation, as recent history attests.
Indeed, if the Government protects all creditors, or is generally
believed to protect all creditors, the other efforts to reduce the
costs of the safety net will be of little benefit. The implications are
similar if the public does not, or cannot, distinguish a bank from its
affiliates. As financial consolidation continues, and as banking
organizations take advantage of a wider range of activities, the
perception that all creditors of large banks, let alone of their
affiliates, are protected by the safety net is a recipe for a vast
misallocation of resources and increasingly intrusive supervision.
Financial Holding Companies and Umbrella Supervision
Mindful of the potential for the Federal safety net to extend
beyond what Congress intended in its enactment of the Gramm-Leach-
Bliley Act (``GLB Act''), the Federal Reserve has been careful to
distinguish between insured depositories and uninsured holding company
affiliates and parent organizations in the supervision of financial
holding companies (``FHC's''). Consequently, the Federal Reserve's
focus in FHC supervision has been to identify and evaluate, on a
consolidated group-wide basis, the significant risks that exist in a
diversified holding company with a view to evaluating how such risks
might affect the safety and soundness of insured depository institution
subsidiaries. Such supervision is not intended to impose bank-like
supervision on FHC's, nor is it intended to duplicate or replace
supervision by the primary bank, thrift, or functional regulators of
FHC subsidiaries. Rather, it seeks, on the one hand, to balance the
objective of protecting the depository institution subsidiaries of
increasingly complex organizations with significant interrelated
activities and risks, against, on the other, the objective of not
imposing an unduly duplicative or onerous burden on the subsidiaries of
the organization.
To accomplish that objective we have relied on our long-standing
relationships with primary bank, thrift, securities, and foreign
supervisors while forging new relationships with the functional
regulators that oversee activities that are newly
permitted under the Act. These relationships respect the individual
statutory authorities and responsibilities of the respective
supervisors, but at the same time, allow for enhanced information flows
and coordination so that individual responsibilities can be carried out
effectively without creating duplication or excessive burden. The
Federal Reserve places substantial reliance on internal management
information maintained by FHC's and on reports filed with, or prepared
by, bank, thrift, and functional regulators, as well as on publicly
available information for both regulated and nonregulated subsidiaries.
Since enactment of the GLB Act, over 500 FHC's have been formed.
The vast majority of those are small community holding companies that
converted largely in an effort to take advantage of the insurance
agency provisions of the GLB Act or to be well positioned should
opportunities for exercising new powers present themselves. Most of the
larger holding companies have also converted to FHC's, and appear to be
taking advantage of the securities, merchant banking, and to a lesser
extent, the insurance provisions of the Act. In addition to the
conversion of existing bank holding companies, there have been a few
nonbank financial service companies that have applied for and received
FHC's status in connection with their acquisition of banking
organizations.
In general, banking organizations appear to be taking a cautious
and incremental approach to exercising new powers under the GLB Act. In
addition, the number of new, truly diversified financial holding
companies across securities, insurance and banking has been few enough
to let organizations and supervisors gradually gain experience and
comfort in their operations.
----------
PREPARED STATEMENT JOHN D. HAWKE, JR.
Comptroller of the Currency, U.S. Department of the Treasury
June 20, 2001
Introduction
Mr. Chairman, Senator Gramm, and Members of the Committee, I
appreciate this opportunity to discuss the condition of the banking
system. I am pleased to report that the last decade has been a period
of economic prosperity and strong growth in the banking sector.
Commercial bank credit grew by over 5 percent per annum during the
1990's. During this period of prosperity, most banks strengthened their
financial positions and improved their risk-management practices.
As a result, the national banking system is in a much better
position to bear the stresses of any economic slowdown. National banks
are reporting strong earnings with a return on equity (ROE) for the
first quarter of this year of 15.2 percent--a level considerably higher
than the ROE of 11.5 percent prior to the last economic slowdown in
1990-1991. Fifty-five percent of banks reported earnings gains from a
year ago. Asset quality for the national banking system is better. The
ratio of noncurrent loans (for example, 90+ days past due and
nonaccrual) to total loans is 1.3 percent, compared to 3.3 percent in
the first quarter of 1990, the year marking the start of the last
slowdown. And capital levels are at historical highs. As of the first
quarter of 2001, the ratio of equity capital to assets was 8.9 percent,
compared to 6.0 percent in the first quarter of 1990.
As we move into the next decade, banks and bank supervisors face
two major challenges. The first is cyclical: how to identify and manage
the risks associated with a slowing economy in the United States and
internationally. Many nonbank companies are experiencing a slowdown in
demand for their products and services. This in turn is prompting a
scaling back of expansion plans and staff reductions, which invariably
will have regional and local economic repercussions for a variety of
bank lending and servicing activities.
The second challenge is structural: how to adapt bank operations
and supervision to the fundamental long-term changes in the banking
industry. The rapid changes in technology, the increased competition in
the market for financial services providers, and the globalization of
financial markets are all presenting significant strategic and
operational challenges for bank management and regulators.
My remarks today will cover four main topics. First, I will discuss
the current state of the national banking system. Second, I will
describe how the national banking system today compares with 1990, just
before the last economic slowdown. I will then highlight the emerging
risks and trends, and I will end with a discussion of the steps that
the OCC has taken and will continue to take to address those risks.
The Current State of the National Banking System
The 1990's were a period of extraordinary earnings for the banking
industry. National banks reported record earnings for 8 consecutive
years as net income rose from $17.3 billion in 1992 to $42.6 billion in
1999. During this period, the annual return on equity averaged 15.2
percent, peaking in 1993 at 16.4 percent [see Figure 1].
Greater diversification of income sources improved the quality of
bank earnings during the 1990's. This diversification trend should
improve the capacity of banks to weather difficult economic times and
better manage the risks embedded in their operations. For example, the
share of banks' revenues coming from noninterest income sources such as
fee income, asset management and trust services, brokerage and trading
activities and fiduciary income increased over the last 10 years from
34 percent to over 45 percent [see Figure 2]. The trend away from
reliance on traditional interest income is in part an active effort by
banks to better manage risk. As a supervisor, we strongly support the
efforts of national banks to diversify their revenue streams through
financially related activities.
The search for new sources of revenue also reflects an effort to
offset the effects of increased competition in traditional lending
activities from nonbank competitors. Interest income grew at the modest
rate of 5 to 6 percent during this period, largely as a consequence of
loan growth. During most of the 1990's, banks' net interest margins
(the spread between what a bank earns on loans and investments and what
it pays for funds) declined, a trend that is unlikely to be reversed.
Because they expect continuing margin declines and slowing growth,
banks have turned to alternative sources of revenue.
Slow revenue growth may become an issue for banks in 2001 if slower
economic growth and weakening equity markets continue. Noninterest
income is likely to be subdued and bank lending is likely to be
sluggish. The most recent Federal Reserve Beige Book published last
week reported declining loan demand in many of the Federal Reserve
Districts as firms in a variety of industries have cancelled or
postponed plans to expand and in some cases are laying off employees.
Another key determinant of the profitability of the banking system
is the quality and performance of its loans. One useful measure of
asset quality is the level of noncurrent loans--those loans with
payments past due at least 90 days or in nonaccrual status, when any
payments received by the bank are used first to pay down principal. The
ratio of noncurrent loans to total loans, which was 4.1 percent in
1991, fell steadily to less than 1 percent in the late 1990's [see
Figure 3]. The low level of noncurrent loans meant that banks were able
to divert a relatively small amount of their revenue each year to loan
loss reserves, which in turn boosted earnings.
The deterioration in credit quality, particularly in the commercial
and industrial (C&I) loan portfolio, began 3 years ago and picked up
steam in 2000. The noncurrent ratio for C&I loans for large banks
increased by 56 basis points last year. While overall credit quality
deterioration was more modest for smaller banks, rising only 3 basis
points in 2000, these nationwide aggregate ratios understate the impact
that the slowdown in economic growth is having on small bank credit
quality in some geographic areas.
Spurred by the slippage in asset quality in 2000, particularly for
C&I loans at large banks, the dollar value of loss provisions (the
additions to loan loss reserves) rose 32 percent over the previous
year. The ratio of provisions to loans rose to 0.95 percent, its
highest rate since 1993. The rise in provisioning was most pronounced
at the large banks and credit card banks, but provisioning at smaller
banks also increased to its highest rate since 1993. Nonetheless,
provisioning remains below the rates experienced during the banking
turmoil of the 1980's and early 1990's.
The weakening in credit quality indicators and slowing of the
economy increases the likelihood that banks will increase the level of
provisioning in coming quarters to cover inherent loan losses. Prior to
the 1990-1991 recession, loan loss reserves, as a percentage of total
loans at national banks, were 2.5 percent, rising to a peak of 2.8
percent in 1992. During the current expansion, by contrast, the
industry-wide loss reserve ratio for national banks declined to 1.8
percent. While loan loss reserves as a percentage of loans have
remained fairly stable at 1.8 percent for the last 2 years, the
coverage ratio of reserves to noncurrent loans has fallen from 184
percent to 138 percent. If the economy continues to slow, causing a
further deterioration in credit quality, banks will be expected to
increase their level of reserves.
The record earnings of the 1990's and good asset quality enabled
national banks to build their capital. The ratio of equity capital to
assets for all national banks rose to 8.9 percent at the end of the
first quarter of 2001, the highest level in nearly four decades [see
Figure 4]. Nearly 98 percent of all national banks met the regulatory
definition of well capitalized by maintaining a ratio of equity capital
to assets above 5 percent and a total capital to risk-based assets
above 10 percent.
Comparison With Prior Economic Slowdown
With the slowing of economic activity in the United States and the
potential for increased financial stress on banking institutions, it is
worthwhile comparing the current condition of national banks to
conditions that existed just prior to the recession of the early
1990's. Indeed, mindful of the stresses that many commercial banks
experienced in the late 1980's, that point is a constant frame of
reference for us as we approach today's supervisory challenges.
For the national banking system as a whole, profitability, asset
quality and capitalization are significantly stronger today than in
1990 [see figure 5]. For example, median income as a percentage of
assets (return on assets, or ROA) was 14 basis points higher in the
first quarter of 2001 than in the same period in 1990. The median ratio
of noncurrent loans to total loans was 92 basis points lower and the
median capital ratio was 160 basis points higher.
The proportion of the banking industry facing the economic slowdown
from a position of weak performance is substantially less than in 1990
just prior to the last recession. For example, less than 1.5 percent of
the banks currently have an equity capital ratio under 6 percent. In
1990, 17 percent of banks had an equity capital ratio under 6 percent.
Banks have also made gains during these years in diversifying
risks. Loan securitization has become a significant funding tool,
enabling banks to generate revenues from loan origination while
shifting credit and interest rate risk off of their balance sheets.
Banks have also broadened the geographic scope of their operations and
increased the range of financial services they offer, providing them
with a greater capacity to weather adverse economic developments.
Advances in information technology have provided bank managers with
advanced risk-management tools that were unavailable a decade ago.
Emerging Risks
While the national banking system is in a stronger position
relative to the last economic slowdown, banks cannot be complacent
about the risks that will continue to surface in the current economic
environment, particularly in the areas of credit and liquidity.
Credit Quality
While the level of loan losses is still relatively low, since 1997
the OCC has been concerned about a lowering of underwriting standards
at many banks. This relaxation of standards stems from the competitive
pressure to maintain earnings in the face of greater competition for
high-quality credits, particularly from nonbank lenders. In some cases,
banks' credit risk-management practices did not keep pace with changes
in standards. We now are beginning to see the consequences of those
market and operational strategies in the rising number of problem
loans.
The deterioration in credit quality indicators that began 3 years
ago has to date been largely concentrated in the C&I loan portfolios of
the larger banks [see Figure 6]. The Asian financial crisis and the
turmoil in the capital markets in the fall of 1998 also put pressure on
large banks' loan portfolios. As capital markets contracted and the
cost of debt became more expensive, corporations turned to the banking
sector for an increasing share of their financing needs. This shift
accounts, in part, for the substantial growth rates that banks have
experienced in C&I lending, leveraged financing, and commercial real
estate and construction financing. While such lending resulted in
strong growth in the banking sector, competition to book these loans
also put pressure on banks' underwriting and risk-management controls.
Emerging credit risk is not just an issue for large banks. As
corporate earnings have weakened, the spillover effects on credit
portfolios are beginning to show up in the smaller institutions.
Community banks (defined as banks with assets under $1 billion) in 33
States and the District of Columbia have experienced an increase in
their noncurrent loans over the last year [see Figure 7]. Particularly
vulnerable to a downturn are banks in manufacturing areas that are
highly dependent on energy production and distribution systems. Areas
that rely heavily on manufacturing are experiencing falling earnings
and slowing or negative employment trends.
We expect credit quality to be an issue for banks throughout 2001,
as the financial positions of some businesses and households weaken due
to slow economic growth. This deterioration in credit quality will be
an added drag on bank earnings.
Liquidity Risks
Funding (or liquidity) risk at banks is also increasing as
households and small businesses reduce their holdings of commercial
bank deposits. Banks have traditionally relied on consumers and small
businesses in their communities as a major source of funding. These so-
called core deposits, most of which are covered by Federal deposit
insurance, have provided a stable and generally nonrate sensitive
source of funding. With the rapid run up in the stock market in the
1990's, however, and the widespread popularity of money market mutual
funds, households and small businesses have increasingly shifted their
savings and transaction accounts into pension funds, equities, and
mutual funds. Deposits in banks and thrifts accounted for 10.5 percent
of household financial assets in 2000, down substantially from 19
percent in 1990 and 22 percent in 1980.
Between 1993 and 2000, while annual asset growth in the banking
system averaged 7 percent, core deposits at banks grew at a rate of
less than 4 percent per year. This lagging growth in core deposits
relative to asset growth is likely to continue.
In response to the long-run, secular trend of slower deposit
growth, banks have turned increasingly to higher interest rate
wholesale funding. Both large and small banks have increased their
reliance on wholesale (noncore deposit) funding sources to finance
their incremental loan and asset growth. While large banks are
accustomed to accessing the capital markets for funding, this is a new
activity for many smaller banks. Because of costs and information
constraints, small banks find it more difficult than large banks to
raise funds through public debt offerings, securitizations, and other
capital market instruments. Thus, we see that small banks are
increasingly relying on wholesale providers such as the Federal Home
Loan Banks as well as deposits obtained through the Internet or CD
listing services. Although these sources can provide community banks
with cost-effective funding, their use requires banks to have more
rigorous management systems to monitor and control funding
concentrations and maturity concentrations.
Consequently, traditional measures of bank liquidity, such as the
ratio of core deposits to assets, reflect increased liquidity risk for
both small and large banks. For example, core deposits as a percentage
of assets for small banks (those with less than $1 billion in assets)
declined from 79.8 percent in 1992, the first year of recovery from the
last recession, to 69.6 percent in 2000. For the larger banks, the core
deposits to assets ratio declined from 56.6 percent in 1992 to 43.9
percent in 2000.
How a bank funds itself is important because when a bank
experiences deteriorating credit quality, it faces the risk of pressure
on its funding and liquidity. Wholesale funds are far more risk- and
price-sensitive than federally insured core deposits. Prudent
management of this type of funding, therefore, is increasingly
important. In particular, community banks that engage in business
lending and have high levels of wholesale funding need to have
effective internal controls and realistic contingency funding plans.
OCC's Approach to Growing Risk in the Banking System
A dynamic and healthy banking system is vital to the functioning of
the overall economy. Our job as bank supervisors is to maintain a sound
banking system by encouraging banks to address problems early so that
they can better weather economic downturns and are in a position to
contribute to economic recovery. As we have seen in the past, banks
whose financial condition is seriously weakened by credit quality
problems are less capable of extending credit because their attention
is necessarily devoted to problem resolution and capital preservation.
By acting early, in a measured and intelligent way, bank
supervisors can moderate the severity of problems in the banking system
that will inevitably arise when the economy weakens. By responding when
we first detect weak banking practices, supervisors can avoid the need
to take more stringent actions during times of economic weakness.
Supervisors are most effective when they take early and carefully
calibrated steps that target potential industry excesses and failures
in risk-management. This approach will help us maintain a healthy
banking system that can continue to extend needed credit to sound
borrowers during difficult economic times.
Since 1997, the OCC has implemented a series of increasingly firm
regulatory responses to rising credit risk and weak lending and risk-
management practices. These efforts, which started with industry
reminders and advisories about the dangers of weakening lending
standards and poor credit risk-management, grew into more focused
examination and policy responses as risks increased.
In 1997, in response to a sharp increase in the incidence of
weakening underwriting standards reported by our examiners, we
required examiners to discuss the results of the 1997 Survey of
Credit Underwriting Practices with their banks' CEO's. We also
instructed examiners to discuss any examples of weak underwriting
disclosed in examinations directly with the bank CEO.
In 1998, in response to further weakening of bank underwriting
and risk selection standards, we implemented the Loans With
Structural Weaknesses initiative to ensure that poorly underwritten
and other higher risk credits were brought directly to the
attention of bank management and boards. We instructed our
examiners to identify such loans in all reports of examination, to
criticize and classify such loans where appropriate, and to
incorporate the amount and severity of weaknesses found into their
conclusions about credit quality and portfolio management, and the
overall condition of the bank. Simultaneously, we formed a team of
our best credit experts to review loans from across the population
of our largest banks to identify examples of the types of
weaknesses our examiners were reporting. Based on this review,
which came to be called the Ugly Loan Project, we developed and
delivered a focused training program. The goals of that program
were to advance the credit risk evaluation and classification
skills of our examiners and to clarify our expectations about how
structural and other credit weaknesses should be incorporated into
their judgments about credit risk in individual loans and
portfolios. We issued a comprehensive guidebook and examination
procedures on Loan Portfolio Management to bankers and examiners to
clearly communicate our expectations for sound portfolio credit
risk-management processes. This guidance covers underwriting, loan
review and approval, exception reporting pricing and portfolio
stress testing.
In 1999, we issued an industry advisory about the growing
risks associated with higher-risk leveraged and enterprise value-
dependent credits. We initiated an effort to improve the
consistency of credit classifications among the banking agencies,
and led the development and issuance of interagency policies on
higher risk subprime and high loan-to-value lending activities.
In 2000, we continued training efforts designed to sharpen our
examiners' risk recognition and credit classification skills, and
led the development of Interagency Risk Management Standards for
Leveraged Loans. This guidance, issued in 2001, establishes
consistent criteria among the agencies for evaluating and
classifying troubled leveraged and enterprise value dependent
loans. We also led the development of Interagency Guidance on
Accounting for Loans Held for Sale, which was issued this year, to
improve public disclosures of credit losses being taken by banks
that are selling problem and other loans in the secondary markets.
Throughout this process we have maintained an open and candid
dialogue with the banking industry and our examiners about rising
credit risk in the system and the need for improved risk-management by
bankers. Through regular meetings with individual bank CEO's and
periodic meetings with groups of CEO's and Chief Credit Officers, we
have discussed the risks involved with some of the weaker credit-
granting practices that seeped back into the system during the mid-to-
late 1990's. We have worked with bankers to identify and mitigate their
higher risk, more vulnerable credits at a time when their capital
accounts and income statements are most capable of absorbing the risk.
We have also insisted on accurate risk identification and disclosure so
market forces are capable of affecting change where appropriate.
National banks have responded positively to these initiatives.
Bankers are adjusting both their risk selection and underwriting
practices. Credit spreads are wider, recent credit transactions are
better underwritten than they were as little as 12 months ago, and
speculative grade and highly leveraged financing activity has slowed in
both the bank and public credit markets.
The widening of credit spreads and tightening of risk selection and
underwriting standards reflect a reassessment of risk tolerance by all
credit providers, not just banks. Bankers are working diligently to
shore up previously weak risk selection and underwriting practices,
improve deficiencies in credit risk identification and risk-management,
and strengthen reserves as appropriate. Our recent examining activities
are confirming these positive responses.
We recognize that we need to ensure a balanced approach as economic
and credit conditions weaken. We have implemented, and will continue to
follow, a careful but firm approach to addressing weak credit practices
and conditions. In this regard, we are constantly mindful that the
alternative approach of silent forbearance can allow problems to fester
and deepen to the point where sound remedial action is no longer
possible--a lesson that all bank supervisors learned painfully in the
late 1980's and early 1990's.
The OCC has also taken a number of steps to address our concerns
about increasing liquidity and funding risk.
Over the past 2 years, we have provided OCC examiners with
specialized liquidity risk-management training. That training
focuses on current funding trends and issues and the importance of
appropriate liquidity management, including bank contingency
funding planning.
In February, we issued a Liquidity Handbook, which outlines
the OCC's expectations with respect to bank's liquidity risk-
management practices. It highlights a number of elements necessary
for successful liquidity management, including a consolidated
liquidity strategy, effective risk-management tools, strong
internal controls, sound contingency funding plans, and reliable
management information systems.
We have held a number of outreach activities and training
programs. Included among them was a telephone seminar, The
Challenges of Sound Liquidity Risk Management. OCC's Expectations
and Policy for Community Banks, held on May 15 and 16, 2001. The
seminar focused specifically on key aspects of managing community
bank liquidity. Staff from over 300 community banks participated in
the seminar.
The OCC authored a Joint Advisory on Brokered and Rate-
Sensitive Deposits, which the bank and thrift regulatory agencies
published in May of this year. The Advisory highlights for banks
the risk-management challenges posed by interest rate and credit-
sensitive sources of funds.
The growing complexity of the banking industry requires us to
develop new and modern tools to help detect emerging weaknesses more
quickly. The OCC has been strengthening our early warning systems,
which now include a set of tools--we call it ``Project Canary''--
designed to enhance our identification of and supervisory responses to
banks that may be more vulnerable to emerging risks. We have created
financial measures based on Call Report data, and we look at changes in
those measures in assessing movement to higher risk position levels,
particularly in the area of credit, interest rate, and liquidity risks.
For each measure, we have established benchmarks to assist in the
identification of those banks with the highest
financial risk positions. While risk taking is necessary in the normal
course of banking, the paramount issue is whether high levels of risk
taking are balanced with commensurate levels of risk-management. Bank
managers, bank directors, and OCC examiners can use this information to
look for high levels of risk and determine if risk-management and
mitigants are appropriate for the given level of risk.
Our early warning system also provides assessments of a bank's
vulnerability to changes in economic conditions. We have developed
several internal models, which we combine with existing external
models, to better define those banks that may be at higher risk of
adverse macroeconomic or regional economic developments. For example,
we can review the potential earnings impact of layoffs in a particular
industry or community for banks in that area.
This early warning system is providing us with information to
better calibrate our supervisory efforts and target the application of
examination resources to the area of highest potential risk. Our
supervisory managers use this information in planning examinations,
allocating resources, and targeting key risks. These early warning
tools also provide a useful, consistent method for identifying
potential risk areas and performing comparative analysis. As such, they
enable examiners and managers to better allocate resources through more
focused examinations and offsite reviews. Supervisory offices use these
measures as an oversight tool, by comparing the early warning reports
to current risk assessments and supervisory plans, so that
inconsistencies can be identified and resolved. And these tools also
help us in assessing and tracking systemic risk.
Conclusion
In conclusion, we believe the condition of the banking industry
today is strong. The vast majority of banks have strong capital and
earnings, improved risk-management processes, and more diversified
revenue streams. As a result, we believe the banking industry today is
better able to withstand adverse economic developments than it was
going into the recession of the early 1990's.
We are, however, in a period of heightened uncertainty concerning
the domestic and global economic outlook. Credit problems are rising in
our banks and we project continued pressure on bank earnings, at least
over the near term. If the U.S. slowdown becomes deeper and persists,
the effects on the banking industry will be much more serious.
Declining earnings would heighten concerns about the safety and
soundness of certain banks.
As supervisors, we have the important responsibility to neither
discourage nor encourage lending but to ensure the soundness of the
banking system. In good times, this is easy. It is more difficult to do
when economic conditions are deteriorating and we are challenged to
ensure that our standards for safety and soundness are neither too
harsh nor too lax. We have experience with the difficult long-term
problems created when bank supervisors failed to act in a timely and
measured fashion and they tried to play catch up after the damage is
done.
If we have learned anything from past economic crises both in the
United States and overseas, we know that a sound banking system is
essential to continued economic growth. I can assure you that the OCC
will remain vigilant in our efforts to continually improve the risk-
management of national banks and thereby maintain a viable, healthy
industry to support our economy.
PREPARED STATEMENT OF DONNA TANOUE
Chair, Federal Deposit Insurance Corporation
June 20, 2001
Mr. Chairman, Senator Gramm, and Members of the Committee, thank
you for the opportunity to testify on behalf of the Federal Deposit
Insurance Corporation (FDIC) regarding the condition of the bank and
thrift industries and the deposit insurance funds.
I am pleased to report that the banking and thrift industries
continue to exhibit strong financial results. However, we are seeing
signs of stress that indicate that this continued strong performance
will be more difficult to maintain in the future. I will highlight
three of these warning signs in my testimony today--subprime lending,
vulnerabilities in the agricultural sector, and funding and liquidity
challenges.
Perhaps the most important message that I will leave with you today
is that there are flaws in the current deposit insurance system and the
best time for constructive debate on changes to deposit insurance is
now, during a period of financial health for the banking and thrift
industries, rather than in the charged atmosphere of a crisis. Today,
depository institutions are strong and profitable. The deposit
insurance funds also are in good financial condition and the FDIC
stands fully prepared to fulfill its commitment to depositors. We
should not, however, assume that these good times will last another
decade. As you know, depositors in all walks of life have come to rely
on FDIC insurance to guarantee that their insured deposits are
absolutely safe. The financial strength of the FDIC and its ability and
commitment to honor its responsibility to depositors are beyond
question. Therefore, I urge this Committee to take advantage of this
timely juncture and to move forward on reform to ensure that the
strength and stability of our deposit insurance system remains
unquestioned.
Condition of the Industry
The banking sector continues to experience strong financial
performance. Commercial banks recently completed their eighth
consecutive year with an industry return on assets above 1 percent. A
return on assets (ROA) of 1 percent or higher has traditionally been a
benchmark of superior earnings performance. Prior to 1993, the
commercial banking industry never had an annual ROA as high as 1
percent. Almost 60 percent of all insured commercial banks reported an
ROA of 1 percent or higher last year.
Three main sources of strength drove bank earnings during this
period of prosperity. First, the improvement in asset quality following
the last recession has meant that expenses for credit losses have been
less of a drain on banks' revenues. Second, noninterest revenues have
been growing rapidly, as the industry has diversified its sources of
income. Third, banks have had strong growth in assets, particularly in
loans, as they have provided necessary credit to a record-breaking
economic expansion.
Many indicators of trouble--unprofitable banks, ``problem'' banks,
undercapitalized banks, bank failures--all remain near their cyclical
lows. Banks' capital has kept pace with the industry's growth. Today,
more than 95 percent of all banks are in the highest regulatory capital
group. The number of ``problem'' banks--78 banks, with $17 billion in
assets at the end of last quarter--is near its cyclical low point.
Our most recent earnings data, which we released earlier this
month, show that net income of commercial banks set a new record in the
first quarter of 2001. However, this record was made possible by
nonrecurring gains on sales of securities. The industry's net operating
income, which more closely reflects the strength of banks' ongoing core
business, was $565 million below the level of a year earlier.
Sustaining these very high levels of profitability has become
increasingly difficult for the banking industry. There is evidence that
many banks have taken on more risk as they have sought to maintain
profitability. At the same time, some of the most important factors
that have contributed to the industry's relative prosperity are
becoming less favorable.
Net interest margins--the difference between what banks earn on
their loans and other investments and what they pay for deposits and
other liabilities--reached a 14 year low in the first quarter. The
margin decline stemmed from increased competition, which has put
downward pressure on loan pricing and upward pressure on funding costs,
and a relatively flat yield curve.
The volume of problem loans has been growing for almost 2 years,
mostly in loans to commercial and industrial (C&I) borrowers at large
banks. Only one-third of all banks are showing deterioration in their
C&I portfolios, but together they account for more than two-thirds of
all C&I loans held by commercial banks. Moreover, most of the
deterioration is centered in larger banks, particularly those with
large and middle market corporate loan portfolios. This deterioration
is reflected in the interagency Shared National Credit review program,
which has reported two straight years of significant increases--albeit
from a very low base--in classified and criticized credit volumes, a 53
percent increase in 1999 and another 44 percent increase in 2000. The
2001 Shared National Credit review is currently in progress and results
will be available later this year, but indications are of a continuing
trend.
Credit card loans, which the FDIC identified as a potential concern
in our 1997 testimony on industry condition, have shown an improved
trend in loan losses since 1998. Up until the first quarter of this
year, this improvement has paralleled an improving trend in personal
bankruptcy filings through the end of 2000. However, personal
bankruptcies in the first quarter of this year were up 18 percent over
the previous year, raising the possibility of higher write-offs of
credit card loans later this year.
As the percentage of troubled loans has risen from cyclical lows,
banks have had to apply an increasing share of their revenues to
provisioning for loan losses. Last year, loss provisions absorbed 8.2
percent of banks' net operating revenues, the highest proportion since
1992. In the first quarter of this year, loss provisions were 36.1
percent higher than a year ago.
Concentrations of traditionally higher risk loans as a percent of
capital also have been on the rise. The forthcoming issue of the FDIC
Regional Outlook, which we will release shortly, shows that the percent
of insured institutions with moderately high concentrations--that is,
commercial and construction loans totaling between 400 and 700 percent
of capital--has increased by more than half since 1995. A greater
percentage of insured institutions, 17.1 percent, has concentrations in
this 400 to 700 percent range now than at any time since at least 1984.
This fact is troubling as history shows that banks with concentrations
such as these consistently tend to fail more often than banks with
lower concentrations--as much as 2 to 3 times as often by some
measures. It is important to recognize that the higher capital levels
we see are accompanied in many cases by higher portfolio risks.
The FDIC is addressing the increase in credit risk in several
different ways. The FDIC employs a risk focused examination approach
that enables examiners to prioritize risk and allocate staff to those
areas of the bank that represent the most risk. Enhanced examination
software tools give our examiners the ability to perform more
sophisticated loan reviews with special emphasis on the higher risk C&I
and construction/development loans. In addition, the FDIC recently
instituted a large bank supervision program that provides more on-going
supervision throughout the year for many of our largest institutions.
Our offsite monitoring programs provide current data on loan growth and
performance trends that are closely reviewed by staff assigned to
monitor each insured bank. We also monitor the industry and local real
estate markets through other vehicles such as the Report on
Underwriting Practices and the Survey of Real Estate Trends. We
continue to work closely with other regulators to improve the
information exchanges and interagency cooperation that are necessary in
today's rapidly evolving banking system. An example is the recently
issued additional guidance to banks on risk-management practices for
leveraged financing.
As we contemplate further weakening in asset quality and slowing
revenue growth in the near term, we should recognize that the banking
industry today is far stronger than when it entered the last economic
downturn more than 10 years ago. Banks now have more opportunities for
geographic diversification and new sources of income. Banks also have
been able to control growth in their overhead expenses, and to steadily
improve efficiency.
Many of the observations made about commercial banks apply to
insured savings institutions as well. While the profitability of
insured savings institutions has been somewhat lower than the
profitability of commercial banks, the past few years have brought
strong earnings and growth for the thrift industry as well. Reflecting
their historical role as providers of financing for homeownership, more
than two-thirds of all loans held by insured savings institutions are
home mortgage loans. At commercial banks, home mortgages account for
less than one quarter of all loans. The large share of home mortgages
in their loan portfolios means that most thrifts have lower net
interest margins and lower credit risk than commercial banks. However,
thrifts are subject to the same competitive pressures, and exhibit many
of the same trends in performance and condition that we see at
commercial banks.
Condition of the Insurance Funds
The two deposit insurance funds managed by the FDIC reflect the
favorable condition of the bank and thrift industries. The Bank
Insurance Fund (BIF) reported a balance of $31.4 billion (unaudited) as
of March 31, 2001, compared to $31 billion at year-end 2000. One BIF-
member institution failed in the first quarter of 2001, and there have
been just 22 BIF-member failures over the preceding 5 years. The BIF
balance has grown in each of the last five quarters, but these
increases failed to keep pace with strong growth in BIF insured
deposits. As a result, the BIF reserve ratio \1\ has drifted downward,
from 1.36 percent of estimated insured deposits at the end of 1999 to
1.32 percent as of March 31, 2001. From March 2000 to March 2001, BIF
insured deposits increased by $180 billion. Nearly one-third of this
amount ($57 billion) can be attributed to two organizations that have
been sweeping brokerage-originated cash management funds into insured-
deposit accounts at BIF-member bank affiliates. The insured deposit
growth at these two organizations--without additional contributions to
the insurance fund--has been enough to account for a 3 basis point
decline in the BIF reserve ratio.
---------------------------------------------------------------------------
\1\ The reserve ratio is the fund balance divided by the dollar
volume of the estimated insured deposits.
---------------------------------------------------------------------------
The Savings Association Insurance Fund (SAIF) also has reported
steady growth, resulting in a balance of $11 billion as of March 31. No
SAIF members have failed thus far in 2001, and only three SAIF members
failed in the preceding 5 years. Recent insured deposit growth has been
relatively strong for the SAIF, although less so than for the BIF. SAIF
insured deposits grew 1.7 percent during the first quarter of 2001 and
5.8 percent during 2000, compared to average annual growth of 0.6
percent in the preceding 5 years. The SAIF reserve ratio stood at 1.43
percent on March 31, which was unchanged from year-end 2000 and down
slightly from 1.45 percent at the end of 1999. Brokerage account sweeps
added an estimated $2 billion to SAIF insured deposits, accounting for
a one-half basis point decline in the SAIF reserve ratio.
Challenges to Continued Strong Performance
A transition from a decade of rapid economic growth to the slower
growth the U.S. economy is now experiencing will, to some degree,
adversely affect bank earnings. The impact is likely to be greatest on
institutions that have been most aggressive in their selection of
risks. In this regard, as they develop risk-management strategies,
insured institutions need to allow for the potential for economic
conditions to be less favorable than prevailed during the 1990's.
Experience suggests that a weakening economy takes some time to
affect banks. I would like to devote some attention to two issues that
are more immediately before us, namely those posed by subprime lenders
and lenders dependent on the agricultural economy. I also will discuss
an issue that is extremely important to many banks today, that of
funding and liquidity.
Subprime Lending
The FDIC continues to have concerns regarding subprime consumer and
mortgage lending. We are closely watching approximately 150
institutions that have subprime lending programs, for example, programs
that purposely target subprime markets, in volumes that equal or exceed
25 percent of capital.
Subprime lending can be--and indeed, has been--beneficial to
borrowers with blemished or limited credit histories and is an
acceptable activity for insured institutions, provided that the
institution has proper safeguards in place. Without these safeguards,
mistakes can be costly, as evidenced by the role subprime lending has
played in recent failures. Subprime lending figured prominently in 6 of
the 20 bank and thrift failures in the past 3\1/2\ years. Further,
since most subprime lenders in the bank and thrift industry have not
been tested in an economic downturn, it is realistic to expect
additional problems for institutions with concentrations of subprime
loans should economic conditions deteriorate further.
Several factors that are very often associated with subprime
lending can create problems for the lenders, their regulators, and for
the FDIC as receiver for failed institutions. One factor is the nature
of the assets created as a by-product of loan securitization. In a
securitization, the subprime lender sells packages of loans to another
party or institution, but often retains the right to receive a portion
of the cashflows expected from the loans. The expected value of these
cashflows is generally referred to as the retained interest, or
residual.
The residual holder's right to receive cashflows is generally a
deeply subordinated position relative to the rights of the other
security holders (as such, they serve as a credit enhancement to the
other securities). To determine the value of this residual, the tender
must make a variety of assumptions about the underlying loans, which
would include delinquency rates, charge-off rates, and discount rates.
As a result, and particularly with subprime loans, the accurate
valuation of the residuals can be extremely difficult, making the
residuals a highly illiquid and very volatile asset. In institutions
with excessive concentrations of residuals, the safety and soundness of
a bank or thrift may be threatened if the valuations turn out to be
overly optimistic.
The complexity of subprime loan securitizations also means that
accounting deficiencies are more likely. In some of the failures
involving subprime lenders that securitized loans, accounting
statements were deemed inadequate or inappropriate by bank supervisors.
Finally, subprime lending programs may use third parties for loan
origination, servicing or other activities. The use of third-party
originators and servicers is a standard business practice that can
reduce bank costs and enhance efficiency. However, poor analysis and
monitoring of loans purchased from third parties have contributed to
the failure or near-failure of a few institutions due to
misrepresentation, and even apparent fraud, on the part of the
originator.
We have intensified our supervisory attention to the roughly 150
banks and thrifts with subprime lending programs. The banking agencies
released the March 1999 Interagency Guidance on Subprime Lending. In
January 2001, the agencies distributed the Expanded Guidance for
Subprime Lending Programs. The focus of our supervisory attention is on
the need for more intensified risk-management procedures and internal
controls for such higher risk lending programs, as well as the need for
appropriate levels of reserves and capital.
Vulnerabilities in the Agriculture Sector
Farm banks remain in a vulnerable position as their profitability
is linked so strongly to the uncertain economics of farming and the
continuance of Government support payments. Without Government
payments, many farmers would have significantly more difficulty meeting
loan payments.
Today, more than 1,900 banks hold more than 25 percent of their
loans in farm loans. While these farm banks constitute some 23 percent
of all commercial banks, these banks tend to be smaller, rural
community institutions, and hold less than 2 percent of all bank
assets. Farm banks are highly sensitive to local economic conditions,
being less diversified in their lending and sources of income. For
instance, noninterest income contributes less than 15 percent of farm
banks' revenue compared to over 43 percent for other commercial banks.
The FDIC is not predicting serious near-term problems in the farm
bank sector. In spite of the well-publicized stress in the agriculture
sector, the performance of farm banks, on average, remains quite steady
with loan quality and capital positions remaining relatively strong.
Only 2 percent of farm banks lost money in 2000. Most farm banks are
currently well capitalized and well managed and generally are in much
better financial condition than they were before the 1980's farm
crisis.
Over the longer term, farm banks face the difficult issue of rural
depopulation. U.S. Census data indicate that the Midwest has most of
the counties in the United States that have lost population since 1970.
Farms have been consolidating for decades, resulting in larger farms
and lower populated rural areas.
To date, two sources of income have helped farmers, and thereby
farm banks, avert a more serious financial crisis. In aggregate, farm
households have come to depend more on off-farm income, mostly wages
and salaries, for their livelihood. In addition, Federal assistance
remains significant, providing 49 cents of every dollar farmers earned
in 2000.
However, the FDIC must remain vigilant for further declines in the
agricultural economy. The U.S. Department of Agriculture currently
forecasts a decline in net cash farm income in 2001 to under $51
billion, down from $56.4 billion last year (assuming no supplemental
assistance for the 2001 crops). Higher energy costs also play a role in
the forecasted decline.
Funding and Liquidity
During this record economic expansion, loan growth in the
commercial banking industry has been exceptionally strong while deposit
growth has failed to keep pace. This raises questions of decreased
liquidity and continued credit availability, especially at community
banks.
Since 1992, loans held on bank balance sheets have increased by
$1.8 trillion or at an 8.3 percent compounded growth rate. In contrast,
core deposits grew by only $709 billion, which translates to a 3.6
percent compounded growth rate. As a result, the share of commercial
banks' assets funded by core deposits has declined steadily from its
peak level of 62 percent at year-end 1992, to 46 percent at the end of
2000. During that same period, the percent of banks' assets that
consists of loans increased from 56 percent to 60 percent.
Pressures stemming from the need to fund rapid loan growth are
particularly evident at community banks, which traditionally have
relied almost exclusively on core deposits to fund balance sheet
growth. In this environment of strong loan demand, the balance sheets
of banks with less than $1 billion in assets have undergone shifts in
the composition of their assets and liabilities that have increased
many community banks' exposure to interest rate risk, credit risk, and
liquidity risk.
Many small banks appear to be liquidating securities to fund loan
growth, and increasing the proportion of higher yielding, higher-risk
loans in their portfolios in order to offset the increased cost of
funding. This has helped to limit the erosion in community bank
profitability in recent years. But these changes have left many small
banks more vulnerable to rising interest rates and a slowing economy.
The ongoing loss of liquidity in banks' balance sheets is evidenced
by the industry's historically high and rising loans-to-assets ratio.
Loans are less liquid, that is, they are harder to convert into cash
than assets such as U.S. Treasury securities or other marketable
securities. Similarly, core deposits are important because they are not
as volatile as many alternative sources of funds. They do not reprice
quickly when interest rates rise, and because they tend to be fully
insured, they do not flow out of banks when concerns about an
institution's health arise. The loss of liquidity is also shown by the
declining ratio of core deposits to assets, as banks have increased the
share of loans in their asset portfolios and funded a growing share of
their assets with nondeposit liabilities.
Increased reliance on liabilities other than core deposits implies
potentially higher and more volatile funding costs for banks. Banks'
inability to fund asset growth exclusively with core deposits has led
to a growing dependence on large certificates of deposit and Federal
Home Loan Bank (FHLB) advances. At the end of 1992, only 4.6 percent of
commercial banks had any FHLB borrowings; these advances provided only
0.2 percent of commercial banks' funding. By the first quarter of this
year, 45 percent of commercial banks had FHLB advances, which supplied
2.9 percent of the industry's funding.
There is no question that FHLB advances and other nondeposit
funding sources play an important role in depository institutions'
liquidity and funds management strategies. New Call Report data showed
that, at the end of March, 52 percent of banks' FHLB advances had
maturities in excess of 3 years. This suggests that many banks are
attempting to use these advances to hedge interest-rate exposures of
their longer-term assets. However, FDIC examiners have raised
supervisory concerns in certain cases when a large concentration of an
institution's funding needs were being met by FHLB advances or other
wholesale funds and management did not fully understand the risks
associated with those funding sources. Late last year, the FDIC issued
guidance to our examiners for reviewing FHLB advances. Finally, on May
11, 2001, the FDIC and the other Federal bank and thrift regulatory
agencies issued a joint advisory on the risks of brokered and other
rate-sensitive deposits that outlined prudent risk identification and
management practices for deposits.
There is some evidence that liquidity pressures are easing. The
past two quarters have seen a pickup in growth in core deposits, led by
increases in money market deposit accounts. These savings accounts,
which offer access to funds while paying interest on balances, can
represent ``safe havens'' for investors seeking risk-free, short-term
investments. Growth in banks' domestic deposits has surpassed growth in
loans for two consecutive quarters. But, two quarters is not a trend,
and it is much too early to determine if recent strong deposit growth
is credible.
Deposit Insurance Reform
Last year, the FDIC initiated a comprehensive review of the deposit
insurance system. Our review identified some important flaws in the
system, which we described in an Options Paper issued last August. I
will describe the flaws and our recommendations for fixing them. A
consensus appears to be emerging in support of several of the FDIC's
recommendations, but some important implementation issues remain. I
urge the Committee to take up these issues with my successor as soon as
practicable, to ensure that we take advantage of the opportunity to
enhance the deposit insurance system in good times, when the industry
is strong.
The Case for Reform
One of the key flaws in today's system is that deposit insurance
premiums do not reflect the risk that individual institutions pose to
the system. Although the FDIC Improvement Act (FDICIA) mandates a risk-
based deposit insurance premium system, other provisions of law
prohibit the FDIC from charging premiums to institutions that are both
well capitalized, as defined by regulation, and well managed (generally
those with the two best examination ratings) when a fund's reserve
ratio is at or above the Designated Reserve Ratio (DRR) of 1.25
percent. As a result, over 92 percent of insured institutions are in
the FDIC's best-risk category and currently pay no deposit insurance
assessment. All institutions pose some risk, and there are significant
and identifiable differences in risk exposure among the institutions in
the best-rated premium category. Indeed, even institutions with
different CAMELS ratings (CAMELS ``1'' or ``2'') pay the same amount
for insurance--zero. Having institutions with different risk
characteristics all paying nothing for insurance renders the risk-based
premium system ineffective, reduces the incentive for banks to avoid
risk and forces safer institutions to subsidize riskier institutions.
The inability to price risk appropriately has had a number of other
negative effects. Since very little in premiums has been collected
since 1996, the deposit insurance system is financed almost entirely by
those institutions that paid premiums in the past. There are currently
over 900 newly chartered institutions, with over $60 billion in insured
deposits, that have never paid premiums.
In addition, deposit insurance that is underpriced creates an
incentive for institutions to grow rapidly. Financial institutions
outside the realm of traditional banking recently began to make greater
use of FDIC insured deposits in their product mix. Large dollar volumes
of investment firm brokerage accounts were swept into deposit accounts
in their FDIC insured subsidiaries. To the extent that these
institutions are in the best-rated premium category, they pay no
insurance premiums for this rapid growth. Since they are not paying for
insurance, new institutions and fast-growing institutions are
benefiting at the expense of their older competitors and slower-growing
competitors. Rapid deposit growth lowers a fund's reserve ratio and
increases the probability that additional failures will push a fund's
reserve ratio below the DRR, resulting in a rapid increase in premiums
for all institutions.
The second flaw in the current deposit insurance system identified
by the FDIC study is that premiums are volatile and are likely to rise
substantially during an economic downturn when financial institutions
can least afford to pay higher premiums. By law, when a deposit
insurance fund's reserve ratio falls below the DRR, the FDIC must raise
premiums by an amount sufficient to bring the reserve ratio back to the
DRR within 1 year, or charge all institutions at least 23 basis points
until the reserve ratio meets the DRR. However, during a period of
heightened insurance losses, both the economy and depository
institutions in general are more likely to be distressed. A 23 basis
point premium at such a point in the business cycle would be a
significant drain on the net income of depository institutions, thereby
impeding credit availability and economic recovery.
In addition to these two key flaws in the deposit insurance system,
our review addressed two other important issues. The first is the
existence of two separate deposit insurance funds. As long as the FDIC
maintains two funds, whose assessment rates are determined
independently, the prospect of a premium differential with its
attendant inefficiencies and inequities exists. Separate funds also are
not as strong as a combined deposit insurance fund would be. Moreover,
because each insurance fund now insures both banks and thrifts, there
is little justification for maintaining separate funds.
The second issue is the erosion in the real value of deposit
insurance over time. Deposit insurance coverage is an important
component of the Federal Government's program to promote financial
stability, yet there is no mechanism for regular adjustments to
maintain its real value as the price level rises.
The FDIC's Recommendations
The FDIC published the following recommendations for reforming our
deposit insurance system on April 5, 2001.
The current statutory restrictions on the FDIC's ability to
charge risk-based premiums to all institutions should be
eliminated; the FDIC should charge premiums on the basis of risk,
independent of the level of the fund.
Sharp premium swings triggered by deviations from the
designated reserve ratio should be eliminated. If the fund falls
below a target level, premiums should increase gradually. If the
fund grows above a target level, funds should be rebated gradually.
Rebates should be determined on the basis of past
contributions to the fund, not on the current assessment base.
The Bank Insurance Fund and the Savings Association Insurance
Fund should be merged.
The deposit insurance coverage level should be indexed to
maintain its real value.
Collectively, these recommendations will result in a deposit
insurance system that will allocate the assessment burden more smoothly
over time and more fairly across institutions. They are not designed to
increase the long-term assessment revenue to the FDIC.
These reforms are designed to be implemented as a package. Picking
and choosing among the parts of the proposal without focusing on the
interaction between the various recommendations could weaken the
deposit insurance system, magnify macroeconomic instability, and
distort economic incentives.
At a general level, a consensus appears to be emerging in support
of several of our conceptual recommendations. There is broadening
agreement that:
The deposit insurance system must be less procyclical. That
is, premiums should not rise sharply during an economic downturn
taking funds out of the banking system when they are needed most to
help fuel a recovery.
The FDIC must be able to charge appropriately for risk, both
because the current system creates perverse incentives and because
riskier institutions should shoulder more of the assessment burden
for deposit insurance.
Reform must address the issue of deposit growth, to lessen the
impact of rapid growers on the rest of the industry and to bring a
measure of fairness to the funding of the deposit insurance
program.
Some important implementation issues remain to be resolved. These
are the issues on which the FDIC will need to focus its discussions and
build consensus going forward. One is how to set the target level for
the fund. It is important to note, however, that a target level, be it
a point or a range, should probably not be fixed permanently. It would
be wise to revisit the performance of the fund and general economic
conditions every few years and adjust accordingly. Another issue is how
to differentiate among institutions on the basis of risk and charge
premiums accordingly. A third issue is how to determine the size and
allocation of rebates.
The FDIC's reform proposals were accompanied by various
illustrative examples of ways of addressing these issues. These issues
require policymakers to weigh and balance important policy goals. For
example, in determining how to price risk across banks, actuarial
judgments must be balanced against public policy goals. On an actuarial
basis, banks with substantial loan concentrations pose a greater risk
to the insurance fund, other things being equal. From a public policy
point of view, however, it may not be desirable to over-penalize
lenders in communities that happen to be dependent upon particular
industries. As the examples illustrate, none of these issues are
insurmountable, and working together we can implement meaningful
deposit insurance reform.
Conclusion
I appreciate the opportunity to testify regarding the overall
strength and prosperity of the banking industry. Today's strong economy
and banking system also provide a window of opportunity to improve the
deposit insurance system. It would be a missed opportunity to wait
until the economy and the banking industry are suffering and the
results of the weaknesses in the deposit insurance system have become
all too evident. The FDIC's recommendations will strengthen the deposit
insurance system, promote economic stability, enhance safety and
soundness, and make the system more equitable.
These reforms will work best if implemented as a package. In
particular, the ability to price for risk is essential to an effective
deposit insurance system. Picking and choosing among the parts of the
proposal could weaken the deposit insurance system, magnify
macroeconomic instability, and distort economic incentives. Trying to
address other issues without addressing risk pricing does not solve one
of the most fundamental flaws in the current system.
I would like to thank Chairman Sarbanes, Senator Gramm, and Members
of the Committee once again for the Committee's interest in this
important issue and for the opportunity to present the FDIC's reform
proposals. I hope that this Committee and the Congress, working with my
successor, will be able to bring about these much needed reforms.
In closing, I also would like to thank my colleagues at the FDIC
who produced the reform recommendations I have discussed and who work
so hard at insuring a safe and sound financial system for the American
people. It has been a pleasure and a privilege to work with them.
----------
PREPARED STATEMENT OF ELLEN SEIDMAN
Director, Office of Thrift Supervision, U.S. Department of the Treasury
June 20, 2001
I. Introduction
Mr. Chairman, thank you for the opportunity to appear before the
Committee to discuss the financial condition and performance of the
thrift industry. As the Director of OTS, I have come to appreciate how
difficult it is to change perceptions. We often hear that perception is
reality. Sometimes perception is reality, but not always. The thrift
industry is a case in point. Today, many of those who do not follow the
industry closely still perceive the industry as being deeply troubled.
The memory of the thrift crisis lingers in the Nation's collective
consciousness. In 1988, one in five thrifts was insolvent. Equity-to-
assets ratios averaged 3.5 percent. In that year alone the industry
reported losses of $13.3 billion.
Working together, President Bush and Congress passed the Financial
Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) to
address the
crisis, and clean-up problem thrifts. By 1991, the thrift industry had
returned to profitability and began a long process of restoration,
stabilization, and strengthening.
Where Is the Industry Today?
Today's thrift industry is strong and growing. Profitability, asset
quality, and other key measures of financial health are at or near
record levels. The average equity-to-assets ratio is over 8 percent,
and 98 percent of thrifts are well capitalized. Problem thrifts and
loan loss rates are very low. Mortgage loan originations are at or near
record levels. And only three thrifts have failed in the past 5 years.
Many factors are responsible for the current health of the thrift
industry. Obviously, the Nation's long-running economic prosperity and
the quality of thrift management are two critical factors. We must also
recognize the contribution of critical statutory and regulatory reforms
that have been initiated over the last twelve years to strengthen the
banking system. The reforms of FIRREA, and the Federal Deposit
Insurance Corporation Improvement Act of 1991 (FDICIA), which mandated
new capital standards, uniform standards for lending, operations and
asset growth, and prompt corrective action, played a large role in
strengthening the system. New supervisory tools and enforcement powers,
such as the Examination Parity and Year 2000 Readiness for Financial
Institutions Act, have given us the ability to intercede more quickly
and forcefully if problems develop at an institution. At OTS we have
worked hard, through recruiting, training, our new accreditation and
professional development programs, and other new supervisory tools, to
make certain our staff is equipped to deal with the challenges of an
ever more complex industry.
II. Condition of the Thrift Industry
As of March 31, 2001, there were 1,059 OTS-regulated thrifts,
holding assets of $953 billion. Though consolidation continues to
reduce the number of thrifts, asset growth has been strong, and assets
are at the highest level since March 1991.
While there are some large thrifts that operate nationwide, most
thrifts are small, community-based financial service providers. As of
the first quarter of 2001, 71 percent of thrifts had assets less than
$250 million. Mutual thrifts comprise 39 percent of the industry, but
have only about 7 percent of the industry's assets. The industry
employs 182,000 people, maintains over 61 million insured deposit
accounts, and holds over $668 billion in housing related-loans and
securities, including $458 billion in whole single-family loans,
representing over 48 percent of thrift assets.
A. Earnings and Profitability
In recent years, the earnings and profitability of the thrift
industry have been strong--a trend that continued into the first
quarter of this year. First quarter earnings were $2.16 billion--the
third best quarterly earnings on record. For the year 2000, the
industry reported earnings of $8.0 billion, just shy of the record
earnings of $8.2 billion posted in 1999.
The industry's return on average assets, a key measure of
profitability, was a healthy 0.92 percent in the first quarter of this
year and 0.91 percent in the year 2000. The industry posted yearly
returns on assets above 0.90 percent for the last 3 years--a feat last
achieved in the late 1950's.
In large part, the strength and stability of the industry's
earnings can be attributed to diversification of income sources, and
strong asset quality.
The industry's success over the past decade in expanding its line
of products and services, such as mutual fund and annuity sales, trust
activities, and transaction accounts, has enabled the industry to
diversify its income stream and generate more stable earnings. Higher
proportions of noninterest income helped stabilize thrift income and
provided better insulation against interest rate fluctuations.
Noninterest income as a percent of thrifts' gross income more than
doubled over the past 10 years to 12.4 percent for 2000 from 5.1
percent in 1990.
Smaller thrifts, as a whole, did not fully participate in the
overall industry earnings expansion. While remaining stable, smaller
thrift earnings have lagged overall industry earnings for the last 3
years. Part of the reason for smaller thrifts' lag in earnings is that
they hold higher than average proportions of lower yielding assets--
cash, U.S. Treasury securities, and nonmortgage related investment
securities. As of the first quarter, thrifts with assets under $100
million held 16.8 percent of their total assets in lower yielding
assets compared to the industry average of 7.4 percent. In addition,
the majority (56 percent) of mutual thrifts had first quarter assets
under $100 million. Mutual thrifts are not under shareholder pressure
to maximize profits and pay dividends. However, mutual thrifts often
``share'' profitability with their owners--depositors--through higher
interest rates and lower fees on deposit accounts. Mutuals are also
active participants in the economic development of their communities.
This sharing of profitability lowers net earnings.
B. Asset Quality
The overall quality of thrift asset portfolios is strong and key
measures of problem loans are at or near historic lows. Troubled assets
(loans 90 or more days past due, loans in nonaccrual status, and
repossessed assets) were 0.62 percent of assets in the first quarter,
slightly above the recent low of 0.58 percent at September 30, 2000.
The ratio of troubled assets-to-total assets has remained below 1
percent since September 1997.
As might be expected in the current economic environment, the level
of delinquent loans has been increasing. The industry's noncurrent loan
ratio increased in the three most recent quarters, albeit from a record
low level. However, less seriously delinquent loans--those 30-89 days
past due--were 0.70 percent of assets in the first quarter, down from
0.74 percent at the end of 2000.
The majority of the overall increase in thrift noncurrent loans was
due to arise in delinquent business-related loans, namely, commercial
loans, nonresidential mortgages, and construction loans. Although the
dollar amount of the typical business-related loan is larger than the
typical consumer-related loan, the industry's total investment in
business-related loans is small--less than 10 percent of all thrift
assets. Thus, the overall increase in noncurrent loans reflects the
delinquency of a small number of loans at a few thrifts.
Loan charge-off rates have also remained at low levels. Net charge-
offs as a percent of total assets were 0.19 percent (annualized) in the
first quarter, down slightly from 0.20 percent in 2000. The low charge-
off rates reflect the high quality of thrift loan portfolios, which are
heavily concentrated in single-family mortgages. Charge-off rates for
single-family mortgages are generally very low compared to other types
of loans. The loan charge-off rate was 0.05 percent of all single-
family mortgages in the first quarter (annualized), or $50 per $100,000
of loans.
Thrifts' loan loss reserves have remained relatively constant at
approximately 1 percent of total loans since 1999, reflecting the low
levels of troubled assets and charge-off rates. The industry's reserve
ratio is somewhat lower than that of the commercial banking industry.
Again, this is due to thrifts' higher percentage of assets held in
mortgage loans, which have lower loss rates than commercial loans.
C. Capital
Capital measures for the industry are strong, stable, and well in
excess of minimum requirements. Equity capital was 8.1 percent of
assets in the first quarter, with 98 percent of the industry exceeding
well-capitalized standards.\1\ Only four thrifts were less than
adequately capitalized at the end of the first quarter, and each is
operating under an OTS-approved capital restoration plan.
---------------------------------------------------------------------------
\1\ On November 3, 2000, OTS and the other Federal banking agencies
requested public comment on an advance notice of proposed rulemaking
that considers establishment of a simplified regulatory capital
framework for noncomplex institutions. And on September 27, 2000, OTS
and the other Federal banking agencies requested public comment on
proposed revisions to capital rules for residual interests in asset
securitizations or other transfers of financial assets.
---------------------------------------------------------------------------
D. Funding Sources
While capital ratios remain strong, the industry has become
somewhat more dependent on wholesale funding as deposit growth has
slowed due to changing savings and investment patterns and the strong
competition from mutual funds. Although deposits remain the primary
source of funding for the industry, the ratio of total deposits-to-
total assets has declined steadily over the past decade. In 1990,
deposits funded 77.0 percent of thrift assets. By the end of first
quarter of 2001, the ratio had declined to 57.0 percent.
Though the dollar volume of deposit growth has slowed, the number
of deposits has increased since 1998, from 50.4 million in 1998, to
61.2 million as of the first quarter of 2001. The average size of small
denomination deposits (those under $100,000) was $6,900 as of the first
quarter of 2001, compared to $8,000 in 1998, reflecting the industry's
increase in noninterest bearing checking accounts that typically carry
relatively small balances. Such deposits increased by 28 percent to
$36.8 billion in the first quarter, from $28.7 billion at the end of
1998.
With deposits declining as a source of funding, the thrift industry
has become more dependent on wholesale funding, primarily in the form
of Federal Home Loan Bank (FHLB) advances. At the end of the first
quarter, FHLB advances funded 22.8 percent of total thrift assets, up
from 7.4 percent in 1991. In addition, other types of borrowings, such
as repurchase agreements, subordinated debt, and Federal funds
purchased, funded 8.9 percent of assets, up from 5.5 percent in 1991.
E. Interest Rate Risk
Interest rate risk remains a key concern in the thrift industry.
Interest rate risk is a natural by-product of the industry's basic
business of making long-term mortgages, which are generally funded with
shorter-term deposits and other borrowings.
Interest rate risk was at the forefront of supervisory concern
during 1999 and early 2000 as rising interest rates and a sharply
inverted yield curve combined to put downward pressure on the
industry's profit margins. Interest rate risk in the industry, however,
has eased considerably since then. Interest rates have fallen
dramatically and the yield curve has returned to a more normal shape.
Thrift management also took steps to change their asset mix to reduce
interest rate risk. Thrifts are now reporting wider net interest
margins and generally lower levels of interest rate risk exposure.
OTS, alone among the Federal bank regulators, has implemented a
stress-test based supervisory strategy for evaluating the interest rate
risk of the institutions we regulate. As a result, both we and the
institutions are able to effectively assess and deal with any increase
in interest rate risk sensitivity arising from changing interest rates
or funding through noncore deposit sources, including FHLB advances
with embedded options. As of the first quarter, 73 percent of all
thrifts were classified as having low levels of interest rate risk, 18
percent as having medium levels, and 9 percent as having higher levels.
Those in the higher risk level category are given close supervisory
scrutiny.\2\
---------------------------------------------------------------------------
\2\ On April 12, 2001, the OTS issued a new Regulatory Handbook
section on Derivative Instruments and Hedging that included an expanded
discussion of risks of using derivatives, a discussion of OTS's policy
on derivatives that incorporates sensitivity analysis or stress testing
from TB13a, and a discussion of FASB's SFAS No. 133, Accounting for
Derivative Instruments and Hedging Activities.
---------------------------------------------------------------------------
F. Problem Thrifts
The number of problem thrifts--those with composite safety and
soundness examination ratings of 4 or 5--remains low. There were 14
problem thrifts at the end of the first quarter, up from 10 in
September 1999--the lowest level since OTS's inception. Assets of
problem thrifts have also remained low and stood at 0.5 percent of
industry assets as of the first quarter. Thrifts categorized as being
in ``problem status'' are subject to increasingly strong supervisory
action to ensure that management and the board of directors move to
resolve the institution's problems.
Thrifts that are rated composite ``3'', while not considered
problem institutions, warrant more than the normal level of supervisory
attention. The number of institutions with 3 ratings rose from a recent
low of 67 in 1998, to 98 by the end of 2000. (The commercial banking
industry had a similar increase in 3-rated institutions during this
period.) By the end of the first quarter, the number had declined to
90. Of these, 91 percent were ``well-capitalized,'' and thus have a
capital cushion that increases their ability to work through their
difficulties in an orderly manner.\3\
---------------------------------------------------------------------------
\3\ On April 30, 2001, the OTS proposed amendments to its
assessment rule that would more accurately reflect the increased costs
of supervising 3-, 4-, and 5-rated institutions.
---------------------------------------------------------------------------
Supervisory attention is also focused on thrifts identified in
other types of examinations, such as compliance, Community Reinvestment
Act (CRA), and information technology (IT), as needing improvement. As
of the first quarter, there were 67 thrifts rated 3 or below in
compliance, including 6 thrifts rated 4 or 5. Sixteen thrifts were
rated less than satisfactory in their CRA examination. Reflecting the
rapid changes in technology, focus on privacy and security concerns,
and increased demand for technologically savvy managers, 35 thrifts
were rated 4 or 5 on their IT exam, and 24 were rated 3. In all cases,
we work with these institutions to help them return to strong ratings.
G. Continuing Role of the Thrift Industry
1. Community Lenders with Residential Focus
Although thrifts can make consumer and, in limited quantities,
commercial loans, they remain primarily focused on residential mortgage
lending. Thrifts originated over 21 percent of all single-family
mortgages made in the United States in the first quarter. Moreover,
thrifts are the dominant originator of adjustable rate mortgages
(ARM's). In the first quarter, roughly 69 percent of all new ARM
originations were made by thrifts.\4\
---------------------------------------------------------------------------
\4\ Mortgage origination market share estimates based on data from
the Mortgage Bankers Association of America and the Federal Housing
Finance Board.
---------------------------------------------------------------------------
The industry originated $74.3 billion in single-family mortgages in
the first quarter, the second highest quarterly volume on record. Since
the end of 1995, the industry has originated over $1 trillion in
single-family home loans.
Single-family mortgage loans and related securities comprised
almost two-thirds of thrift assets in the first quarter. In addition,
4.7 percent of thrift assets were held in multifamily mortgages,
bringing the percentage of assets held in residential-related loans and
securities to 70.1 percent.
While thrifts are primarily residential mortgage lenders, they have
become more active in consumer and commercial business lending. The
industry's ratio of consumer loans-to-assets was 6.3 percent in the
first quarter, up from 4.5 percent at the end of 1990. Utilizing the
expanded small business lending authority granted by the Economic
Growth and Regulatory Paperwork Reduction Act of 1996, the industry's
ratio of commercial loans-to-assets stood at 3.0 percent in the first
quarter, up from 1.5 percent at the end of 1997.
Thrifts also help their communities by making mortgages on
hospitals, nursing homes, farms, churches, stores, and other commercial
properties. Such loans comprised 4.0 percent of thrifts' assets in the
first quarter.
2. Full Range of Financial Services
Besides loans and deposits, thrifts provide a wide range of savings
and investment products to their communities. The industry's sales of
mutual funds and annuities, and trust assets administered, have risen
dramatically over the past 5 years. Total sales of mutual funds and
annuities were $2.9 billion in the first quarter of 2001, and $12.8
billion for the year 2000, compared to $6.4 billion in 1995. Trust
assets administered totaled $427.4 billion as of the first quarter
versus $13.6 billion at the end of 1995.
III. Risks Facing the Industry
A. Credit Risk
While the overall financial condition of the thrift industry is
strong, the current economic slowdown suggests that rising levels of
delinquent loans are a distinct possibility. In terms of credit risk,
the industry's largest exposure is in residential mortgage loans.
Fortunately, however, the housing market is very strong in most areas
of the country and delinquencies on single-family residential loans
have remained at very low levels. Barring a serious downturn in the
economy, which seems unlikely, the credit quality of residential
mortgage portfolios should remain healthy.
The slowdown in economic activity, however, is bound to have a bad
effect on marginal credits, particularly overextended consumers and
commercial borrowers.
Thrifts are not immune to weakness in the business sector since 3.0
percent of thrift assets are held in commercial loans. Nor is the
industry immune to problems in the consumer sector. In recent years,
debt service burdens of consumers have generally grown more rapidly
than their incomes, and the rate of consumer savings of disposable
income has been disturbingly low.
Not surprisingly, banks and thrifts have been tightening credit
standards, building loss reserves, and otherwise fortifying their
balance sheets. As we have learned from experience, it is not
sufficient to rely solely on bank and thrift managers to ensure the
safety and soundness of the system. Vigilant supervision is important,
particularly in a banking system such as ours where deposit insurance,
together with ever-tougher competition, can blunt market discipline and
encourage undue risk-taking by some institutions.
Given the current economic environment, we are placing increased
emphasis on credit review in our examination process. OTS examiners are
focusing on thrifts' credit quality, reserve policies, and capital
adequacy. The loan monitoring, loan collection, and work out procedures
of thrifts are being given increased scrutiny. Particular attention is
being given to business-related loans originated during the height of
the economic expansion.
B. Liquidity Risk/Funding Changes
We are also closely monitoring thrifts' liquidity, although it
should be stressed that liquidity problems are rare in the industry,
and when they do occur, are invariably triggered by weaknesses such as
problem loans.\5\ While an insured depository institution is solvent
and has eligible collateral, liquidity is available. Nevertheless, the
thrift industry as a whole has become decidedly more dependent on
wholesale funding in recent years, and loan-to-deposit ratios have been
increasing. These trends reflect the recent slow pace of deposit growth
as well as our very competitive financial markets in which banks and
thrifts must carefully balance the trade-off between liquidity and
profitability.\6\
---------------------------------------------------------------------------
\5\ On March 15, 2001, OTS issued an interim rule to implement the
recent repeal of the statutory liquidity requirement. The rule removes
the regulation that requires savings associations to maintain an
average daily balance of liquid assets of at least 4 percent of its
liquidity base.
\6\ On May 11, 2001, OTS and the other Federal banking agencies
issued an advisory on the risks of brokered and other rate sensitive
deposits. On June 8, 2001, OTS issued Examiner Guidance on wholesale
borrowings. On June 19, we issued a Thrift Bulletin that outlines sound
principles for liquidity management. That bulletin stresses the
importance of liquidity policies and procedures, management oversight,
contingency planning, and scenario analysis.
---------------------------------------------------------------------------
C. Operational Risk
Operational risk, which includes the risk of loss due to technical
failures and human error, seems to be an ever-present and growing
concern in the financial services industry. The growth of internet
banking, the outsourcing of core banking functions, and the rapid pace
of technological and financial innovation has created new challenges
and concerns.
Advances in technology have also created opportunities for thrifts,
especially in the areas of marketing and broadening customer services.
Thrifts also utilize technology to increase their understanding of
certain credits, enabling better product pricing. The use of technology
for these purposes is encouraged but must be done so responsibly.
Our IT examiners, and increasingly, technology-trained safety and
soundness examiners, focus on how well thrifts' use of technology are
designed and monitored to minimize operational risk and ensure thrift
and customer security and privacy.
Given the recent financial difficulties experienced by many ``high-
tech'' companies, thrifts' contingency planning is receiving increased
supervisory attention.\7\
---------------------------------------------------------------------------
\7\ On June 11, 2001, OTS published a request for comment pursuant
to section 729 of the Gramm-Leach-Bliley Act. OTS and the other Federal
banking agencies are studying their regulations on the delivery of
financial services. The purpose of the study is to report findings and
conclusions to Congress, together with recommendations for appropriate
legislative or regulatory action to adapt existing requirements to
online banking and lending.
---------------------------------------------------------------------------
D. Increasingly Competitive Environment
The increasingly competitive environment in the financial services
industry has forced thrift executives to search not only for ways to
cut costs but also for new business opportunities, which often have a
more extreme risk/return profile than the traditional thrift business.
Subprime lending, whether home equity or credit cards, is one such
business. Well-managed subprime lending, with responsible marketing,
pricing and terms, is an important element in expanding credit access.
But the business is fraught with danger for consumers, institutions,
and the deposit insurance funds when an excess of zeal for short-term
profitability overcomes responsible management and monitoring,
including adequate reserving and capitalization.\8\
---------------------------------------------------------------------------
\8\ On January 31, 2001, OTS and the other Federal banking agencies
issued expanded guidance intended to strengthen the examination and
supervision of institutions with significant subprime lending programs.
The guidance supplements previous subprime lending guidance issued
March 1, 1999.
---------------------------------------------------------------------------
Guiding an institution through these shoals successfully is, of
course, the responsibility of each institution's management and board
of directors. The willingness of management and directors to understand
and manage risk is one of the primary underpinnings of a safe and sound
operation. A key part of OTS's supervisory strategy is to hold regular
meetings with senior thrift managers. OTS's regional supervisory staffs
meet regularly with thrift senior managers during onsite examinations
and to discuss items of supervisory interest. OTS also holds meetings
and conferences with senior managers from multiple thrifts to share
ideas and discuss trends affecting the industry. During the past 18
months, OTS held 24 town meetings involving 240 thrifts; 20 Financial
Management Seminars with 740 attendees; five Directors' Forums that
attracted 1,275 attendees; and a Leadership Conference attended by over
400 thrift CEO's and directors from about 250 institutions.
Thrift senior managers at these meetings voiced several common
issues. First and foremost was that thrifts operate in a very
competitive environment, especially in the conforming single-family
mortgage market. This means thrifts need to think and plan
strategically, especially given the country's changing economy and
demographics. To ensure long-term profitability and earnings growth,
many thrift managers are focused on finding new markets to serve and
analyzing new business lines. These managers strongly feel that niche
markets, emerging markets, and markets neglected or forgotten after
``mega mergers'' reduced local banking presence offer good
opportunities for profitable expansion.
Each thrift must adopt its own strategy to compete in an
increasingly competitive environment. Our examination focus is to
ensure that thrifts have the requisite managerial expertise, sound
policies and procedures, and adequate systems before entering new lines
of business. We also follow up to ensure that institutions effectively
manage and monitor these business lines once entered.
IV. OTS Focus During the Next Twelve Months
A. Ensure Problem Thrifts Have Capable Management
Onsite examinations and regular offsite financial monitoring are
two of the tools we use to keep on top of issues and institutions, and
ensure thrift management and boards of directors are adequately
addressing weaknesses. Two other supervisory tools that we use to
monitor problem institutions are the Regional Managers Group meetings,
which happen 10 times a year, and high-risk videoconferences, which
happen 3 times a year for each region--a total of 15 3- to 5-hour
meetings to discuss high risk or high profile institutions each year.
These tools enable us to learn from each other, enhance consistency
across the country, and stay on top of problem institutions, while
retaining primary responsibility for supervision in our regions.
B. Functional Regulation
OTS has made a considerable effort in the last several years to
reach out to other State and Federal functional regulators to
coordinate and streamline the potential overlapping regulatory
interests. These activities involve meetings, regular communications,
and joint activities and programs, often through various supervisory
coordinating entities such as the National Association of Insurance
Commissioners (NAIC), the National Association of Securities Dealers
(NASD), and the North American Securities Administrators Association
(NASAA).
We have worked extensively over the last several years with the
NAIC to coordinate the regulatory overlap that has developed with
increased insurance company acquisitions of thrift institutions. As a
result of this coordination, OTS has in place information sharing
agreements with 45 State insurance regulators. These efforts include
frequent appearances by OTS and NAIC officials at programs sponsored by
OTS and by the NAIC or by individual NAIC State members. We have also
sponsored several joint programs. OTS's senior managers have attended
NAIC training sessions on the State insurance regulatory system.
Likewise, the State insurance commissioners, their staff, and NAIC's
staff attended an OTS-sponsored training program about the thrift
regulatory system.\9\ Our Regional Directors have working relationships
with insurance commissioners in States in their region where insurance
companies that own thrifts are domiciled.
---------------------------------------------------------------------------
\9\ OTS and the other Federal banking agencies issued final
consumer protection rules for the sale of insurance products by
depository institutions on December 4, 2000. The final rule implements
section 305 of the Gramm-Leach-Bliley Act. As required by the statute,
the agencies consulted with the NAIC.
---------------------------------------------------------------------------
OTS's regional staff also coordinate closely with their regional
counterparts at the NASD on issues of common interest involving
securities activities by thrift service corporations engaged in
securities brokerage activities. Similarly, we have developed a good
working relationship with staff of the NASAA that enables us to
coordinate and leverage our resources to achieve success in areas of
mutual interest. We continue to work with the SEC on policy matters
(such as the privacy regulations required under the Gramm-Leach-Bliley
Act) and, occasionally, on matters involving specific institutions.
C. Coordination With Other Federal Banking Agencies (FBA's) and
State Banking Regulators
OTS also works closely with other FBA's and State bank regulators,
both through the Federal Financial Institutions Examination Council
(FFIEC) and individually, where appropriate, to identify emerging
issues in the financial institutions industry and to coordinate
supervisory activities. This activity occurs both in Washington and at
the regional level, directly with other regulators and through the
Conference of State Bank Supervisors (CSBS). Topics of mutual interest
include emerging risks, adverse trends, and other supervisory matters.
This is a mutually beneficial relationship that keeps all parties
apprised of potential problems, emerging issues, and possible overlaps
of regulatory authority that may pose potential regulatory burdens or
gaps in regulatory coverage.\10\ For example, in connection with
proposed OTS regulations on mutual savings associations and mutual
holding companies, we have met with seven State banking commissioners.
CSBS was very helpful in arranging these meetings.
---------------------------------------------------------------------------
\10\ OTS supervises 148 State-chartered savings associations and 32
thrift holding company structures whose thrifts subsidiaries are all
State-chartered. This role, which is similar to that of the FDIC and
the Federal Reserve with respect to State-chartered commercial banks
and savings banks, requires significant coordination with State bank
regulators on a day-to-day basis in our regions.
---------------------------------------------------------------------------
In matters involving preemption, we notify the appropriate State
regulator to obtain their views when an institution asks us to opine
that HOLA preempts a particular State regulatory action. If we issue an
opinion we send a copy to the State regulator and CSBS.
D. Keep Supervisory Staff Well Trained and Informed
Another aspect of our regulatory oversight is OTS's focus on
dynamic, needs-based employee training. We have inventoried the skill
sets possessed by all of our examiners and, utilizing that information,
are able to identify needed areas of training. This typically involves
a periodic assessment by regional supervisors of upcoming and emerging
issues at institutions in the region, an assessment of the strength of
regional examiners in the skills required to address these needs, and
training targeted to address areas of need. Our new Professional
Development Program, geared to enhancing individual competencies and
skills; specialty examiner tracks; accreditation programs; and a soon-
to-be-piloted management development program, keep employee skills at
top levels.
OTS examiners typically receive training several times annually.
Our training is designed for maximum impact with minimum disruption to
the day-to-day operations of the agency. Training is delivered in
various forms, including computer-based programs, videoconferencing,
outside programs, and by pooling specialized examiner resources so
individuals can share their expertise nationally within the agency.
Both our trust and IT examiners, although regionally based, work across
the country, and the agency's credit card specialists are always on
call to deal with this specialized set of risks. During 2000, examiners
worked cross-regionally for a total of almost 800 days, and we had 19
details to Washington. These exchanges enhance the skills and
perspective of both the sending and recipient offices.
In addition to our internal training activities, we work closely
with the other FFIEC agencies to identify areas that warrant more
extensive and coordinated training initiatives. This past year, the
FFIEC piloted the concept of just-in-time training on CD to get
training on hot issues such as subprime lending and privacy out quickly
to a wide audience. We hold staff conferences and teleconferences to
promote sharing of ideas and experiences among supervisory staff. We
are also improving our information systems to simplify and expedite
access to internal and publicly available thrift and market
information.
E. Early Warning Systems
We are increasing our use of offsite early warning systems to help
pinpoint potential problem areas. In addition to our Net Portfolio
(NPV) Model, OTS examiners and analysts utilize our Risk Assessment
Model (RAM) and our recently implemented Risk Monitoring System (RMS)
to assist offsite financial analysis. Both risk identification models
utilize financial ``triggers and hits'' to quickly identify areas that
need special attention and analyses. The RMS also provides our
examiners and analysts with direct links to thrift web sites, thrift
stock price data, SEC filings, and general economic information, all
used to closely monitor and analyze thrift operations between onsite
exams.
V. Items for Legislative Consideration
We are developing a list of legislative proposals for your
consideration that would reduce regulatory burden on the thrift
industry, streamline and improve OTS supervisory authority, and make
technical corrections. The items we are studying include:
Statutory authority for a Deputy Director of OTS. This would
avoid the potential for gaps in OTS regulatory and enforcement
authority if there is a vacancy in the office of the Director. This
is particularly important because of the delay inherent in filling
vacancies for Presidential appointments.
Permitting Federal thrifts to merge and consolidate with their
nonthrift subsidiaries directly. Today, a Federal thrift may only
merge with another depository institution. We have recently learned
of a situation where current law will cost the institution an
estimated $11 million to structure a merger in a way that is
consistent with existing law.
Modernizing thrift community development investment authority
to permit investments to promote the public welfare and remove
obsolete provisions based on HUD programs that have been off the
books for 20 years.
Eliminating the requirement that a service company subsidiary
of a thrift must be organized under the laws of the State where the
home office of the thrift is located. This geographic restriction
was imposed before interstate branching, the Internet, and
telephone banking, and today simply serves no useful purpose.
Enhanced small business and consumer lending authority to
enable thrifts to better serve the credit needs of their
communities.
An exception from broker-dealer registration by thrifts
equivalent to the exception that banks have under the Securities
Exchange Act of 1934. The SEC has issued an interim rule
accomplishing this result, but it may be appropriate to confirm the
change by statute.
An exception from investment adviser registration by thrifts
equivalent to the exception that banks have under the Investment
Advisers Act of 1940. The SEC has announced it is considering
rulemaking to address this issue, but, as with the broker-dealer
exception, a confirming statutory amendment appears appropriate.
After our final policy reviews and consultation with other affected
agencies, we plan to submit a package of legislative proposals with a
recommendation for their enactment.
VI. Conclusion
Over the past several years, the thrift industry has expanded and
diversified while achieving strong financial results. At OTS, we have
used this time to ensure that our staff and technology is poised to
deal with new risks and to assist the institutions we supervise as they
move into new areas, so they are properly focused on long-term
profitability and responsible service to their customers and
communities. The challenges continue, but both the industry and the
agency are well-positioned to meet them.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES FROM ALAN
GREENPAN
Q.1. What do you think is the single greatest potential problem
facing the U.S. financial system today?
A.1. Considering the challenging economic environment of recent
months, our financial system remains in remarkably good shape.
Certainly an important concern facing the U.S. banking system
is the deterioration in credit quality. Much of the erosion is
the result of a weakening in underwriting standards, especially
in the 1996-1998 period. To date, financial institutions have
shown the capacity to absorb emerging problems in severely
affected segments of their loan portfolios. Problems have been
for textiles, health care, media, agriculture, computer,
telecommunications and other technology segments. More broadly,
other segments of bank loan portfolios, including corporate,
real estate, and consumer portfolios, have shown only moderate
weakness to date. Should the domestic economy slow further or
contract, the performance of these portfolios could deteriorate
placing pressure on the earnings and, if the downturn were
severe, potentially the capital bases of financial
institutions.
At the present time, the U.S. financial system is better
prepared to enter a period of economic weakness than in the
past by virtue of stronger capital bases, loan loss reserves
and more active risk-management techniques. Despite the
increase in problem credits, financial institutions have also
continued to provide credit to sound borrowers. Still,
financial institution managers, regulators and policy makers
must remain vigilant for deteriorating conditions and take
necessary actions to address emerging problems so that these
institutions are able to continue to perform their essential
intermediation function for the U.S. economy even under weaker
conditions.
Q.2. While many analysts predict a recovery from the current
economic slowdown in the second half of the year, there is
still a chance that the downturn could be worse than expected.
If the economy were to underperform, what consequences would
that have for the safety and soundness of the banking system?
Specifically, I would like to ask about the banking
system's risk exposure in the following areas:
Noncurrent Loans
Credit Card and Consumer Loans
Mortgage Delinquencies
Telecommunications Sector
A.2.
Noncurrent Loans
Please see the answer to question 3.
Credit Card and Consumer Loans
With regard to the risk exposure from credit card and
consumer loans, these loans amount to about 10 percent of bank
balance sheet assets, though another 5 percentage points is
also held indirectly through credit card securitizations. Over
the past decade, banking organizations have taken advantage of
scoring models and other techniques for efficiently advancing
credit to a broader spectrum of consumers and small businesses
than ever before. In doing so, they have made credit available
to segments of borrowers that are more highly leveraged and
that have less experience in managing their finances through
difficult periods. In recent years, intense competition for
customers and the expansion of credit to weaker or more highly
leveraged segments resulted in record net charge-off levels for
credit card portfolios. In the last 2 years, net charge-offs
have declined to a lower level but are still moderately above
average. Nevertheless, this particular business line remains
highly profitable for most banks as higher interest rates on
credit card loans are offsetting higher credit costs. In
addition, with the recent slowdown in the economy, rising
personal bankruptcies, an increasing unemployment rate, and a
modest deterioration in loan quality, lenders have tempered
their outlook, tightening their standards somewhat for credit
cards and other consumer loans.
Should the economy weaken further, credit card net charge-
offs would likely rise, possibly fairly rapidly. The effect on
individual banks would depend largely upon the portion of
leveraged consumers in their credit card portfolios. Banks
would feel earnings pressure both directly from credit cards
funded on balance sheets and from lower noninterest income on
securitized credit cards. In extreme cases, high charge-off
rates could trigger early amortization clauses of securitized
credit card pools, causing a rapid return of credit card
receivables to bank balance sheets, resulting in both credit
and liquidity pressures. At present, given current capital
levels, strong earnings, and adequate reserves, deterioration
in the consumer portfolio is most likely to be more of an
earnings issue than a capital concern.
Mortgage Delinquencies
Credit quality for mortgage loans has eroded somewhat in
recent periods, but remains historically in line with the
healthy quality of the past several years. During the first
quarter, noncurrent mortgage loans totaled 0.95 percent of the
portfolio at insured commercial banks, compared to 0.90 percent
at year end and were roughly equal with the level at year end
1997. Since the collateral for the vast majority of mortgage
loans is the borrower's residence, borrowers tend to attempt to
remain current on their mortgages even during difficult times.
Consequently, mortgage loans tend to perform better during
tougher economic times than other consumer loans. Moreover,
though certain residential housing markets have experienced
price weaknesses during downturns, the loss experience on
mortgage loans has generally been modest. For example, in 1991
the proportion of mortgage loans that were noncurrent totaled
1.64 percent, with total portfolio net charge-offs a modest 17
basis points.
Telecommunications Sector
Please see the answer to question 6.
Q.3. After 5 very good years, the rate of nonperforming
commercial, industrial, and personal loans increased by 26.6%
in 2000. Can you please tell me what stress, if any, this
places on the banking system, and whether or not you expect a
similar rate of increase for this current year?
A.3. At present, the banking system is better prepared for a
potential further softening in the economy than in past
decades. For example, just prior to the last recession, the
overhang of effects from problem developing country loans and
mounting commercial real estate problems at insured commercial
banks resulted in noncurrent \1\ loans totaling 3.7 percent of
total loans; that compares to just 1.2 percent today. Moreover,
in 1990 noncurrent loans amounted to nearly 30 percent of tier
1 capital and reserves, compared to 8.6 percent at the end of
the first quarter of 2001. In addition, bank earnings relative
to assets were just 48 basis points in 1990 compared to the 120
achieved in 2000 and 128 in the first quarter of 2001, despite
higher provisions from weakening asset quality. In addition,
1990 earnings were much more dependent on loan quality, while
earnings today are more diversified.
---------------------------------------------------------------------------
\1\ Loans 90 days or more delinquent or nonaccruing.
---------------------------------------------------------------------------
During 2000, noncurrent loans at insured commercial bank
rose by 30 percent, and in the first quarter of 2001 were up by
an annualized 33 percent. It is likely that noncurrent loans
will continue to rise throughout the course of 2001 and perhaps
into early 2002 as well before peaking. However, at that rate
of growth such deterioration would generally place pressure on
bank earnings, but not on capital adequacy.
Q.4. Though the delinquency rates for credit cards and consumer
loans are well below the high levels experienced during the
last economic downturn, they have risen back to levels
comparable to 1993. What do you think the effects of this
increase in delinquency rates will be, with regard to both
consumers and the financial institutions that you regulate?
A.4. Delinquency rates on a variety of consumer loans have
returned to high levels in recent periods and do suggest
increased strain on the finances of some U.S. households. As
indicated in the response to question 7, these pressures also
appear in historically high levels of debt service burden and
personal bankruptcies are at an elevated level. Although
measures of household net worth continue to be benefitted from
higher home prices, important questions remain about the
willingness and ability of consumers to sustain recent trends.
Through the first quarter, the deterioration in consumer loan
portfolios remains within the range of what would normally be
expected during a period of economic weakness and does not
appear particularly threatening either to U.S. households or
their lending institutions. Continued slippage, however, could
cause heightened concern. Through 2000 and for the first
quarter of this year, credit card net charge-off rates for
insured commercial banks were only modestly above the average
loss rate for the decade of the 1990's and were below the peak
rates of 1997 and 1998. Loss rates on installment loans have
been at moderately high levels since 1997 (around 1.04 percent)
without notably disruptive effects, but have increased in the
first quarter of 2001, to 1.20 percent.
Overall, consumer lending (including securitized credit
card receivables that are managed, but off-balance sheet)
represents about 15 percent of commercial bank assets, with
most exposures relating to credit cards. Although most credit
card exposures, in turn, are held by roughly 30 so-called
``credit card banks,'' those institutions remain both highly
profitable and are typically owned by larger, well-diversified
banking organizations. The earnings and capital bases and
increasingly sophisticated risk-management practices of both
the credit card banks and their parent institutions mitigate
supervisory concerns related to the consumer sector. Recent
Federal Reserve surveys of bank lending practices and other
supervisory indicators also suggest that lenders are closely
monitoring their exposures and are tightening standards and
terms on consumer loans in response to declining quality. As
noted in response to question 2, any deterioration in the
strength of consumer loan portfolios will most likely be
limited to the banks' reported earnings rather than their
capital.
Q.5. According to a Mortgage Bankers Association survey, 10% of
mortgages backed by the Federal Housing Administration are now
30 or more days delinquent. An article in the June 12 New York
Times stated that, ``The mortgage problems underscore one main
reason many policymakers and economists are so concerned about
whether the United States will enter a recession this year.''
Can you please tell the Committee your thoughts and concerns
about the high level of mortgage delinquency?
A.5. While delinquencies by FHA mortgage holders jumped several
quarters ago, mortgage delinquencies by holders of conventional
mortgages, by far the larger share of the market, have risen
only slightly during this time. That said, one must still be
concerned about the recent sharp increase in FHA delinquencies
because many FHA borrowers would likely be among the first
households adversely affected by an economic slowdown, and the
situation bears close watching to see if mortgage delinquency
becomes more prevalent among conventional mortgage holders.
Q.6. I have heard from varying persons that the banking
industry has significant exposure in the telecommunications
sector. What is the direct and indirect exposure of banks to
the fall-out in the telecommunications sector?
A.6. The banking industry has been active in underwriting bonds
and originating large credit facilities for the
telecommunications sector. During the recent telecommunication
expansion, the banking industry has worked to syndicate credits
to a diverse array of investors, thus spreading and
diversifying risk within and outside of the U.S. banking
industry. In practice, the originating agent bank retains only
a small portion of the underlying credit by participating out
the vast majority of the commitment to other U.S. and foreign
banking organizations, asset managers, and insurance companies.
In addition, bank loans are generally more senior to bond
holders in bankruptcy so that the severity of losses upon
default tends to be less severe than for other creditors. In
addition, these loans are generally structured with covenants
that can limit further draws on the outstanding commitment if
the borrower's condition deteriorates.
In particular, based on data from the interagency Shared
National Credit program for 2001, the 10 largest U.S. bank
holding companies had outstanding telecommunication balances
relative to tier 1 and reserves ranging from as little as 1.8
percent to as high as 18.1 percent. Including commitments to
lend, which some telecommunication companies may be unable to
draw, exposures ranged from 5.7 percent to 43 percent of tier 1
capital and reserves. It should be noted that the
telecommunications industry has a number of different segments
not all of which are experiencing difficulties. In addition,
much of the credit is to borrowers with investment grade credit
ratings.
That said, signs of weakness in the telecommunications and
other high technology sectors are troubling and could place
pressure more broadly on the U.S. economy should layoffs in
this sector continue and should the effects of a pull back in
technology investment spillover into other sectors. In
particular, in the first quarter of this year, there has been a
pronounced increase in nationwide office vacancies that has
resulted in a negative net absorption of office space in the
United States. That poor performance, the worst in 20 years,
has been attributed by some market observers to the abrupt
return of office space to the market by technology firms and to
delays by prospective tenants hoping that softening conditions
will lower rents further. Whether the first quarter represents
a temporary phenomenon or the beginning of a longer-term trend
remains to be seen, but the need for institutions to continue a
realistic assessment of conditions and stress test their
portfolios is paramount.
As emphasized earlier, the banking industry is well
positioned to meet emerging asset quality weaknesses. As
telecommunication and other technology firms reassess their
business strategies to better reflect current market
conditions, creditors will be challenged to ensure that they
make appropriate risk-return tradeoffs while continuing to
provide credit to sound borrowers.
Q.7. According to the OCC, consumers are more highly leveraged
now than at any measured point in history. Not only are debt
service payments at historic highs, but the increase in debt
has been financed through instruments other than mortgages.
Credit card debt is rising very rapidly; the Chicago Sun-Times
reported that the average credit card debt per household is
$8,123 and has grown threefold over the past decade. Debt
service payments constitute over 14% of disposable income. What
do you believe the effects of this high level of personal debt
will be with regard to consumers, the banking sector, and the
economy as a whole? If the economic downturn is worse than
expected, what would be the effect of having so many people so
highly leveraged?
A.7. Over the past 2 years, mortgages and other types of
consumer debt have increased substantially more rapidly than
disposable income. As a result, the debt service burden,
defined as the ratio of required payments on mortgages and
other types of consumer loans to disposable income, is close to
14\1/2\ percent--the top of the range seen in the 20 year
history of this series. However, even with these large
increases in household debt, the dramatic gains in household
assets in recent years have pushed household net worth (assets
minus liabilities) to a high level by historical standards.
According to the latest published data, household net worth at
the end of the first quarter of this year was about five and a
half times disposable personal income, up from about five times
disposable personal income at the beginning of 1996.
That said, there are signs that the economic slowdown has
put some households under increased financial strain. For
example, bankruptcy filings have run at an elevated rate this
year, and some measures of delinquencies on loans to
households--including, for example, those on mortgages
described in the answer to question 5--have increased recently.
If this strain were to worsen or become more widespread,
households might curtail the growth of their spending further,
which would dampen increases in overall output. As a result,
the Federal Reserve continues to monitor carefully household
financial positions.
Q.8. Remittances are a large and growing economic reality that
affect millions of people both in America and south of the
border. It has recently come to my attention that this
industry, which recent estimates have put at more than $20
billion annually, often charges high fees and that many of the
leading companies have been challenged in court for having
hidden fees. In a New York Times article it is stated that
``the fees have run from about 10 percent to 25 percent or
more.'' Do you believe that there are problems in the manner in
which the bulk of remittances are made today? What steps has
your agency taken to analyze possible solutions including
fostering or creating alternative transfer mechanisms?
A.8. Both banks and nonbanks in the United States currently
provide cross-border money transfer services to residents of
the United States. These services include traditional
electronic wire transfers between a U.S. bank and its overseas
correspondent using telecommunications networks such as SWIFT;
electronic money transfer services provided by nonbanks such as
MoneyGram or Western Union; ATM withdrawals overseas using
international EFT networks to debit the cardholders' U.S. bank
accounts; and other emerging networks.
The fees associated with cross-border remittances by
individuals may include charges for initiating the transfer
itself, charges to convert U.S. dollars to a foreign currency,
and sometimes, fees for the receipt of funds by beneficiaries.
Fees may vary by service provider, service, point of origin,
point of destination, amount of money sent, and the method of
funding the payment. Based on a quick, informal survey of a few
nonbank money transmitters, we found the quoted fees ranged
from $6 to $15 for transfer amounts of $100 and from $15 to $68
for transfer amounts of $1,000, depending on the destination
country and the service used. Currency exchange charges are
additional if delivery is to be made in the local currency.
Receivers are not charged any fees according to the surveyed
institutions.
By comparison several large U.S. banks have said they
charge between $35 and $45 to send a consumer international
wire transfer and typically add foreign exchange charges if the
money is to be delivered in the local currency. Additional
charges also may be imposed on beneficiaries by the receiving
bank for delivery of funds. In the cross-border context, bank
charges for consumer wire transfers can frequently be higher
than the fees charged by nonbank money transmitters due to
lower volumes of activity, additional handling costs, and
correspondent banking fees.
At the present time, the market appears to provide
consumers with several accessible, rapid, and efficient cross-
border transfer services. As a result of increasing competition
and growing volumes of remittances, fees for making cross-
border consumer transfers also appear to be decreasing,
although costs still vary significantly across companies and
countries. Looking ahead, the technological change and the
projected strong growth of overseas remittances may well
continue to increase competition, decrease processing costs,
lower fees, and increase the number of alternatives for making
cross-border transfers.
For its part, the Federal Reserve continues to analyze
issues related to cross-border payments, including alternatives
to promote greater efficiency. For example, the Federal Reserve
has been exploring whether general improvements could be made
in handling cross-border funds transfers using the automated
clearing house (ACH), a system by which many U.S. consumers
receive electronic payroll deposits and Government benefits.
The Federal Reserve recently launched a service for sending
cross-border payments to Canada through the ACH and, later this
year, will be investigating the feasibility of crossborder ACH
payments with Mexico and other countries. In addition, the
Federal Reserve is working closely with industry groups on
potential improvements to cross-border payments. One such
industry effort, lead by the National Automated Clearing House
Association, an industry group, is a global effort to improve
cross-border ACH payments, known as WATCH (Worldwide Automated
Transaction Clearing House). The Federal Reserve has also been
in discussion about the cost, timing, and transparency of
cross-border transfers with other central banks, most recently
through the G-10 central banks' Committee on Payment and
Settlement Systems.
Financial Literacy and Education
Q.9. Former Treasury Secretary Summers has stated that ``all
high school students should receive a financial education,''
and that ``though personal financial education must begin in
the home, it must continue in the schools.'' Can you please
comment on the state of financial literacy and education among
Americans, including any deficiency in this area that should be
addressed? If you see any deficiencies, what do you believe can
and should be done with regard to these deficiencies in both a
broad sense and with regard to your agency? At the hearing I
asked for information regarding any initiatives that your
agency has taken, including the Money Smart program. Could you
please provide this information in your submission to the
record?
A.9. Recent studies by the Jump$tart Coalition and the Consumer
Federation of America confirm that gaps in financial literacy
levels exist among both youth and adults. The Jump$tart
Coalition found that, on average, students in a 2000 financial
literacy exam answered only about 52 percent of the questions
correctly. The Consumer Federation of America administered a
consumer literacy quiz to 1,700 adults nationwide; the average
score was 75 percent correct.
Our sense is that programs and resources for dealing with
these gaps in financial literacy are plentiful. For example,
surveys by the Woodstock Institute and the Fannie Mae
Foundation indicate that numerous school and community-based
programs focus on financial literacy (see Tools for Survival:
An Analysis of Financial Literacy Programs for Lower-Income
Families [2000], Woodstock Institute; and Personal Finance and
the Rush to Competence: Financial Literacy Education in the
U.S. [2001], Fannie Mae Foundation).
The major difficulty seems to be in bringing people,
programs, and resources together in a timely and meaningful
way. Partnerships among organizations and groups are one
approach to addressing this difficulty. The Federal Reserve is
participating in financial literacy partnerships at several
levels. The Board is represented on the Board of Directors of
the Jump$tart Coalition, and a majority of the Federal Reserve
Banks are members of the State coalitions of Jump$tart. For
example, staff at the Federal Reserve Bank of New York led a
public/private network to encourage the New York State
Department of Education to incorporate personal financial
literacy into the mandated high school economics curriculum for
the State of New York.
Board staff have been engaged over the past year in
discussions with colleagues in the National Partnership for
Financial Empowerment, a nonpartisan coalition initiated by
Treasury, and serve on two work groups on minority outreach and
working with Native Americans.
Across the System, Federal Reserve staff based in our
Community Affairs and Public Information programs work with
community development organizations and school systems to
provide
financial and economic education resources to the community.
Initiatives such as the Federal Reserve System's Project
Money Smart (developed by the Federal Reserve Bank of Chicago)
and Building Wealth (developed by the Federal Reserve Bank of
Dallas) are designed to provide information in printed
brochures and through their web sites, with links to a wide
variety of financial literacy resources. On the Project Money
Smart web site, for example, consumers are linked to
information on budgeting, savings, credit, mortgages, and
financial institutions. On the Building Wealth web site,
consumers can compare different savings and investment choices
and calculate the future value of their savings.
Q.10. What steps has the Federal Reserve taken to promote
technology and innovation in the payments system, and what
steps should it take? As well, are you concerned that the
initiation of payments on the Internet, or through another
electronic means, could affect the safe operation of the
payment systems?
A.10. The Federal Reserve has taken a number of steps to
promote technology and innovation in the payment system. With
respect to its own systems, the Federal Reserve has
consolidated the number of its computer centers and centralized
software over the past decade to reduce costs and increase the
efficiency of its electronic payment systems. These initiatives
have enabled the Federal Reserve to cut the prices for its
electronic payment services by more than half since the mid-
1990's.
The Federal Reserve is also adapting services to use
Internet protocols and web technology internally and for
communicating with customers. In addition, the Reserve Banks
are using web technology to make some low-risk services (for
example, cash ordering, savings bond purchases, and check
information) available via the Internet.\2\ In the future, the
Reserve Banks may consider offering higher risk services (for
example, Fedwire funds transfers) through the Internet or an
extranet if sufficient security and quality of service could be
guaranteed.
---------------------------------------------------------------------------
\2\ The Reserve Banks are also conducting a pilot to enable banks
to originate off-line book-entry securities transactions over the
Internet.
---------------------------------------------------------------------------
Given the large number of checks that continue to be
written in this country (roughly 70 billion a year), the
Federal Reserve has also focused significant attention to using
technology to improve the efficiency of the check system. The
Federal Reserve has played a leadership role for many years in
the development of the technology and associated standards for
capturing, exchanging, and storing check images. More recently,
the Federal Reserve Banks have been participating in a
multiyear project to create a standard for their check
processing operations and to enhance electronic check services,
such as the delivery of check data and images to its bank
customers.
The Federal Reserve is also taking additional steps to
promote the use of electronics in payments services in the
belief that such payments can be less costly and more efficient
than paper-based payments. Earlier this year, for instance,
Board staff revised its commentary to Regulation E, which
implements the Electronic Fund Transfer Act, to clarify
requirements for authorizing electronic fund transfers and for
using the Internet to enroll customers in electronic bill
payment arrangements, as well as how the regulation applies to
certain electronic transactions.
The Board has also asked the Payments System Development
Committee (co-chaired by Vice Chairman Roger Ferguson and
Federal Reserve Bank of Boston President Cathy Minehan) to work
collaboratively with the private sector to explore
opportunities for improving the payments system. The Committee
has focused on several issues and has taken a market-oriented
approach toward payment system innovation. As part of its
efforts, the Committee and Federal Reserve staff are working
with a number of standards-setting organizations to facilitate
increased interoperability in the payments system.
This Committee has also sought information from the private
sector on other barriers to innovation and takes steps to
address these barriers when appropriate. One such effort
involves promoting the use of standard message formats when
transmitting electronic files of check information for
presentment. Another ongoing effort involves cooperation with
banking industry and consumer representatives to determine how
to address some of the legal impediments to the expanded use of
truncation in check processing to reduce the cost of
transporting and processing paper checks. Removing these
impediments would require Congressional action.
As noted earlier, the large-value U.S. payment systems
cannot currently be accessed over the Internet. Security
concerns and other technical issues, such as the inability to
ensure service quality, limit the desirability of using the
Internet for such systems. Most core clearing and settlement
systems for retail payments similarly do not use the Internet
for interbank clearing and settlement operations at this time.
To conduct business over the Internet with the general
public, many firms permit credit cards and some firms also
permit automated clearing house transactions created from the
information on a paper check (frequently referred to as a
``electronic check'' or an ``e-check'') to be used to pay for
goods and services ordered over the Internet. The various firms
and clearing organizations involved in these transactions are
experimenting with different arrangements for security and
liability. At this stage, the Federal Reserve is continuing to
monitor the rapidly changing developments in this area and to
discuss these developments with the private sector. The Federal
Reserve has not expressed public concerns about specific
systems. To the extent payments are initiated through banks,
bank supervisory policies pertaining to banking over the
Internet would be relevant.
Q.11. Over the last decade, core deposits have declined as a
percentage of bank and thrift assets, as individuals have taken
advantage of new investment options. Declining deposits have
forced banks to look elsewhere for sources of liquidity. Small
community banks, which may have limited access to alternative
funding sources, are increasingly relying on advances from the
Federal Home Loan Banks as a way to meet their liquidity needs.
Do you have any comments on this development and its
implications, if any, for the financial services industry?
A.11. At smaller banks (those with assets less than $500
million), the proportion of assets funded by FHLB advances rose
from 3.8 percent to 6.3 percent between year-end 1995 and year-
end 2000. Larger banks showed a similar increase--from 3.4
percent to 6.7 percent--suggesting that the banking system as a
whole--and not just community banks--has been increasing its
use of FHLB advances. This relatively limited usage by banks of
FHLB advances to fund assets suggests that, to date, the
subsidy provided by the FHLB's is not so substantial as to
greatly limit banks' use of private sector sources of funding.
With less than 15 percent of FHLB advances flowing to community
banks, and with the use of advances by community banks being
similar to that of larger institutions, neither the FHLB System
nor the community banks appear, in general, to be uniquely
dependent on each other. Of course, as I have noted in other
forums, it is not clear that the FHLB System is either an
efficient or cost effective way to subsidize housing or
community development because the bulk of its subsidy goes to
larger institutions and is not targeted toward the
disadvantaged groups. It is appropriate that Congress
occasionally review the role of FHLB's, just as it should
periodically review all forms of subsidized credit and credit
allocation mechanisms it has created, to determine if the role
played by these organizations is still needed and justified.
Q.12. According to the Japanese banking industry's own publicly
disclosed numbers, about 30 percent of bank assets are
classified by examiners as having problems. Experience in the
United States and other industrialized countries indicates that
if a bank has classified assets of 10 percent to 15 percent of
total assets, it is in danger of becoming insolvent and needs
immediate supervisory action. The Finance Minister of Japan is
reported to have said a few months ago that ``Japan's fiscal
situation is at the verge of collapse.'' Data from various
official and academic sources indicate Japan's government debt
is well over 100 percent of GDP and growing rapidly, and some
experts believe Japan is reaching its financing limits.
Q.12.a. What is your assessment of the Japanese banking system?
Q.12.b. What risk, if any, does the situation in Japan pose to
both U.S. financial institutions and to the U.S. economy?
Q.12.c. What actions should be taken to improve it?
A.12.a. A combination of bad loans left over from the ``bubble
economy'' and new bad loans from a weak economy have left
Japanese banks with sizable asset quality problems. Sizable
portfolios of problem loans suppress bank earnings, create
uncertainty about bank asset values, and distract bank
management from the business of making new loans.
A.12.b. U.S. banks and bank supervisory authorities are aware
of the asset quality problems at Japanese banks and are alert
to the risks they may pose. U.S. banks manage their exposures
to Japanese banks with these risks in mind. In addition, U.S.
bank supervisory authorities pay careful attention to the
activities of the U.S. operations of Japanese banks.
A.12.c. A key step to improve the situation is to reduce the
problem loans of Japanese banks. The Japanese government has
recently announced a plan that aims to do so. In addition, the
plan aims to lower the exposure of Japanese banks to swings in
equity prices. This plan has the potential to improve the
condition of the banks and hence, the soundness of Japanese
financial system. How aggressively the plan is implemented will
be critical in determining its success.
Q.13. There have been reports that Argentina is facing serious
economic peril. What can you tell us on the situation in
Argentina? What effect, if any, do you see on the U.S. economy
as a whole, and specifically on the financial sector?
A.13. Argentina is in the midst of a recession that began in
mid-1998. This prolonged downturn, in combination with
traditionally poor tax collection, has generated shortfalls in
fiscal revenues and contributed to the Federal government's
sizable budget deficits. In addition, Argentina's external
position is characterized by significant vulnerability, as the
country has at times struggled to service its heavy external
debt.
In December 2000, as financial market anxiety about the
outlook for Argentina's economy became acute, the country was
granted a 3 year financial assistance package, including $14
billion in loans from the IMF, as well as financing from
various other official and private sources. To qualify for
these funds, Argentina has been required to implement policies
designed to strengthen its fiscal performance and stimulate
growth. In addition, the Government has moved to reduce its
debt-servicing burden in the short run with a $30 billion debt
exchange, which was completed in early June. However, none of
these efforts has proved sufficient to restore confidence among
investors, and Argentine financial markets are currently
experiencing a severe degree of pressure.
U.S. trade with Argentina is minimal, accounting for less
than 1 percent of our exports and imports. Accordingly, the
direct impact through trade channels of disruptions in
Argentina should be limited. On the financial side, the
linkages are somewhat greater but, even so, the vulnerability
of the U.S. financial system does not seem to be substantial.
The exposure of U.S. institutions to Argentina is small
relative to their combined capital. Argentina is a sizable
presence in the market for developing-country debt, but the
prolonged nature of Argentina's economic problems has
presumably allowed investors time to adjust their portfolios in
response to the increasing level of risk. However, other
emerging market economies are experiencing some spillover
effects. The managing director of the IMF has announced a
proposed extension of Brazil's support program to strengthen
Brazil's financial resources.
Q.14. In a speech before the American Bankers Association,
Federal Reserve Board of Governors Member Edward Gramlich said
that, ``Higher rates of national savings are among the unsung
heroes of the good U.S. economic performance in the late
1990's.'' However, the most recent data from the White House
shows a substantial decline in personal savings, from over 5
percent in 1996 to minus 0.9 percent today. Do you think that
this is a serious problem, and if so, what can we do to
ameliorate it? What position does this place Americans in if
the economic slowdown worsens? Finally, what are the effects of
this decline with respect to national investment levels and GDP
growth?
A.14. The general decline in the personal saving rate over the
past two decades has been a source of concern for policymakers.
The recent precipitous decline of the personal saving rate into
negative territory has heightened these concerns but needs to
be evaluated with respect to other developments in households'
financial situations. While personal saving as a percentage of
personal disposable income declined from 1996 to today,
households' net worth--measured in the Federal Reserve Board's
Flow of Fund accounts--rose from about five times personal
disposable income at the beginning of 1996 to more than five
and a half times personal disposable income today. Households
have reacted to this increase in wealth by boosting their
spending relative to their current income. Because saving is
measured in the national income accounts as the difference
between current income (not including capital gains) and
spending, the additional spending supported by wealth increases
has resulted in lower measured personal saving. That said,
there are still valid concerns about whether households are
saving enough to help fund investment in the economy, and
whether households are adequately prepared for retirement.
Recent research by economists at the Federal Reserve Board
using data from our Flow of Funds Accounts and Surveys of
Consumer Finances suggests that the latest decline in personal
saving rates is primarily a consequence of a plummeting saving
rate for high-income households, which are generally the type
of households most able to weather an economic slowdown. Lower-
income households are generally more susceptible to problems
during less robust economic times, but these are not the
households whose saving rates have been declining in recent
years. While it is certainly appropriate for policymakers to be
concerned about the financial situations of households during
an economic slowdown, the personal saving rate is not
necessarily the best indicator of potential trouble.
The level of investment in the U.S. economy has played a
very important part in increasing productivity and real GDP
growth in recent years. As Governor Gramlich indicated in his
recent speech before the American Bankers Association, national
saving is an important determinant of national investment.
National saving comprises personal saving, business saving, and
Government saving, and thus a decline in personal saving would
lead to a decrease in national saving if all other sources of
saving remained the same. In recent years national saving has
been rising primarily because the increase in Government saving
and, to a lesser degree, the increase in business saving have
more than offset the decline in personal saving. Moreover,
these divergent trends are not necessarily unrelated. For
example, strong corporate profits bolstered business saving and
helped spur the significant capital gains in corporate stocks.
Tax payments on realized capital gains boosted Government
saving while at the same time contributing to the decline in
personal saving. Thus, all sources of saving must be considered
when looking at the funds available for investment.
Q.15.a. What forms, if any, of bank surveillance are done
through automated technology and/or the Internet?
Q.15.b. Does your agency have any plans to augment the role of
automated technology in gathering and disseminating
information?
A.15.a. To supplement on-site examination activities, the
Federal Reserve routinely monitors the financial condition and
performance of banks and bank holding companies using automated
screening systems. These surveillance systems utilize financial
data reported on quarterly regulatory reports and focus heavily
on identifying banking organizations that are exhibiting
problems or deteriorating so that examination resources can be
directed to troubled companies. Further, surveillance screens
are used to flag companies engaged in new or complex activities
to assist examiners in planning on-site examinations.
Currently, specialized surveillance programs are run quarterly
for State member banks, small shell bank holding companies, and
the remaining larger and more complex banking holding
companies. The Federal Reserve also uses an automated screening
system to monitor compliance by financial holding companies
with the requirements of the Gramm-Leach-Bliley Act.
In addition, the Federal Reserve utilizes an automated
system to produce Uniform Bank Holding Company Performance
Reports, which include detailed current and historical
financial and peer group information for individual banking
organizations. These reports are primary analytical tools for
examiners and are also provided to management at bank holding
companies. With the exception of a small number of confidential
items, these reports are also made available to the public.
Recent surveillance initiatives have focused on achieving
timely electronic delivery of surveillance information. For
example, the Federal Reserve has included a number of
surveillance notifications in its Banking Organization National
Desktop (BOND) application. These notifications push screening
results and data directly to the e-mailbox of analysts and
examiners responsible for supervising complex banking
organizations. The Federal Reserve also maintains other
computer applications that facilitate access to financial data
from regulatory reports and to surveillance program results for
all banks and BHC's. For instance, using the Performance Report
Information and Surveillance Monitoring (PRISM) application,
examiners and analysts can readily access the Board's extensive
database of financial and surveillance data and perform
customized analyses of trends and developments at supervised
institutions. Examiners and supervisory staff can also generate
electronic reports that summarize surveillance program results
for individual banking organizations.
A.15.b. Regarding the augmentation of the role of technology in
the gathering of information, beginning in September 2001 the
Federal Reserve will implement a web based system that will
allow financial and bank holding companies to file their FR
Y10-Report of Changes in Organizational Structure via the
Internet. This system will assist the institutions in the
completion of the form and will allow them to provide the data
electronically. On a trial basis, the system is being made
available to a small set of holding companies in September and,
gradually, the population of holding companies will be expanded
over the coming months. Approximately 6 months later, we plan
to expand the population further to include foreign banking
organizations that operate in the United States and are
required to file the FR Y10f. We hope to expand this capability
to other regulatory reports in the near future. We have also
established a capability to receive automated downloads of loan
data from State member banks to assist in the preparation of
examinations, and we receive shared national credit data
electronically from respondent institutions. Last, we
participate with the FFIEC agencies in the automated collection
of Call Reports and HMDA and CRA data from banks. We are
working with the FFIEC Reports Task Force to examine the
possibility of using Extensible Markup Language (XML) as an
alternative for the Call Report and potentially other
regulatory reports in the future.
Regarding further automation in the dissemination of
information, the Federal Reserve places much of its publicly
available regulatory information on the Board of Governor's web
site (www.federalreserve.gov). The public can also access
several educational and training tools, as well as studies and
reports related to community and economic development. We
disseminate public regulatory report information through our
National Information Center web site (www.ffiec.gov/nic), and
HMDA and CRA information, data, and reports through the FFIEC
HMDA (www.ffiec.gov/hmd) and CRA (www.ffiec.gov/cra) web sites.
In addition, through the FFIEC web site (www.ffiec.gov/info-
services.htm), we provide access to a mapping tool, geocoding
tool, and the census data that the FFIEC uses to create HMDA
and CRA reports.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR ENSIGN FROM ALAN
GREENSPAN
Q.1. What is your insight regarding the status of the pending
regulation by the Federal Reserve Board and the Treasury
Department that would redefine real estate brokerage and
management as financial activities?
A.1. The Board received more than 46,000 comments from the
public in response to the invitation by the Board and the
Secretary of the Treasury for comment on whether real estate
brokerage and management activities are financial in nature or
incidental to a financial activity. We believe that it is
important to consider the public comments and other relevant
information carefully.
The Staff of the Board and the Treasury Department are in
the process of reviewing and analyzing the information that the
public has provided. Because of the volume of comments and
information provided, that process will take some time.
Q.2 What are your views regarding the impact the proposed rule
could have on the real estate brokerage industry and the
financial services industry?
A.2. I do not have any firm views regarding the appropriate
resolution of the proposal or the impact that various outcomes
might have on the real estate industry or the financial
services industry. The Board will consider these matters, along
with the other standards enumerated in the Gramm-Leach-Bliley
Act, as part of its review of the comments and the proposal.
Q.3. Real estate brokerage was not specifically addressed in
the Gramm-Leach-Bliley legislation that was enacted into law at
the end of the 106th Congress. Can you discuss your views of
the Congressional intent of Gramm-Leach-Bliley regarding real
estate brokerage's definition as a financial activity?
A.3. The Gramm-Leach-Bliley Act expanded the authority of
companies that qualify as financial holding companies to engage
in new activities and affiliate with other companies. The Act
specifically listed a number of activities that Congress
determined to be financial in nature and, therefore,
permissible by statute for FHC's and their affiliates to
conduct. These activities include broad securities underwriting
activities, insurance underwriting and agency activities,
merchant banking activities, activities previously determined
by the Board to be closely related to banking, and activities
that the Board has previously found by rule to be usual in
connection with the conduct of banking abroad.
In addition to this list of specific activities, Congress
specifically included in the Gramm-Leach-Bliley Act a provision
that allows financial holding companies to engage in any
activity that the Board, in consultation with the Secretary of
the Treasury, determines to be ``financial in nature or
incidental to a financial activity.'' This provision was
included in order to grant the Board and the Secretary
flexibility to address and permit activities that were not
addressed by Congress.
In determining whether an activity is financial in nature
or incidental to a financial activity, the Act requires the
Board and the Secretary to consider a number of factors
including whether the activity is necessary or appropriate to
allow a financial holding company ``to compete effectively with
any company seeking to provide financial services in the United
States.'' In addition, the Act requires the Board and the
Secretary to consider the purposes of the Bank Holding Company
Act and the Gramm-Leach-Bliley Act, changes or reasonably
expected changes in the marketplace in which financial holding
companies compete and in the technology for delivering
financial services, as well as other factors. While Congress
included a provision allowing the agencies flexibility in
defining permissible activities, Congress determined not to
include a provision in the Gramm-Leach-Bliley Act that would
have allowed the general mixing of banking and commerce within
financial holding companies. At the heart of the debate
regarding real estate brokerage activities is the question
whether real estate brokerage activities involve activities
that are financial in nature or commercial in nature. The
commenters focus on this issue and the Board will carefully
consider this matter as it reviews the comments and consults
with the Secretary of the Treasury.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES FROM JOHN D.
HAWKE JR.
Q.1. What do you think is the greatest potential problem facing
the U.S. financial system today?
A.1. The main issues are credit risk and liquidity risk. The
costs of managing these risks will likely cause earnings to
decline in future quarters. The degree of the decline is
contingent on the length and depth of the economic slowdown in
the United States and overseas. The slowdown in the
manufacturing sector is causing deterioration in asset quality
not only in the large banks' commercial & industrial (C&I) loan
category but also for C&I loans in some smaller banks across
the country.
Banks also are reporting a steady decline in their deposit
base resulting in increasing liquidity risk. The decline can be
attributed in part to the strong gains in the equity markets in
the 1990's, which has encouraged households to move their funds
to higher yielding assets. For banks, this means that they must
seek alternative sources of funding, which can be more rate and
market sensitive. Managing the more rate-sensitive and
potentially volatile sources of funding is a challenge for both
large and small banks.
Q.2. While many analysts predict a recovery from the current
economic slowdown in the second half of the year, there is
still a chance that the downturn could be worse than expected.
If the economy were to perform below expectations, what
consequences would that have for the safety and the soundness
of the banking system?
Specifically, I would like to ask about the banking
system's risk exposure in the following areas:
Noncurrent Loans
Credit Card and Consumer Loans
Mortgage Delinquencies
Telecommunications Sector
A.2. Bank earnings will remain under pressure if the slowdown
in economic growth continues. Noncurrent loans in the banking
system are expected to increase for at least the remainder of
2001. If the banking system is subjected to long-term and deep
economic weaknesses, some bank failures may occur. As I noted
in my testimony, the national banking system is in a stronger
position today to bear the stresses of an economic slowdown
than a decade ago--it is better capitalized, earnings are
stronger, bank balance sheets and revenue streams are generally
more diversified, banks' risk-management systems have improved,
and the asset quality of the national banking system is
certainly better.
Even with their profitability under pressure, banks
strengthened their capital ratios over the last year. The level
of capital in the national banking system remains at a
historical high and provides an additional cushion against
unexpected losses--the risk-based capital ratio was 12.1
percent at the end of first quarter 2001, compared to 9.0
percent at the end of first quarter 1990. Moreover, the portion
of the banking industry facing the economic slowdown from a
position of weak performance is substantially less than a
decade ago. Nearly 98 percent of all national banks met the
regulatory definition of well-capitalized by maintaining a
ratio of equity capital to assets above 5 percent and a total
capital to risk-based assets ratio above 10 percent.
The bulleted topics of this question are addressed
separately in the responses to questions 3 through 6.
Q.3. After 5 very good years, the rate of nonperforming
commercial, industrial, and personal loans increased by 26.5
percent in 2000. Can you please tell me what stress, if any,
this places on the banking system and whether or not you expect
a similar rate of increase for this current year?
A.3. The deterioration in asset quality has affected bank
earnings through higher loan loss provisioning to increase loan
loss reserves. While the coverage ratio of loss reserves to
noncurrent loans declined at the end of first quarter 2001 to
its lowest level since 1993, it still remains high at 138
percent and well exceeds the 68 percent coverage level at year
end 1990. As noted above, the national banking system remains
well capitalized, and even with their profitability under
pressure, banks strengthened their capital ratios over the last
year.
There are signs of increasing credit risk in the banking
system, as the financial positions of some businesses and
households are weakening due to slow economic growth. The
greatest deterioration in credit quality has been in the
Commercial & Industrial (C&I) loans category. The noncurrent
C&I loan ratio rose by 22 basis points from 1.66 percent at
year end 2000 to 1.88 percent at the end of first quarter 2001.
While the deterioration has been more pronounced for large
national banks, there were signs it has begun to spread to
smaller banks. The concentration of the problem in business
lending tracks developments in the overall economy with
corporate profits declining and bond default rates rising.
Therefore, banks' C&I loan quality is expected to continue to
deteriorate if the economy continues to weaken.
Q.4. Though the delinquency rates for credit cards and consumer
loans are well below the levels experienced during the last
economic slowdown, they have risen back to levels comparable to
1993. What do you think the effects of this increase in
delinquency rates will be, with regard to both consumers and
the financial institutions you regulate?
A.4. Consumer lending remains a concern given the high consumer
debt levels and the potential reliance of the consumer on more
variable sources of income to service that debt. Consumers'
indebtedness today relative to their income is at an all time
high. If there is a prolonged slowdown and localized areas see
sharp increases in layoffs, consumer defaults on loans may
increase. As a result, banks may experience rising noncurrent
ratios and charge-offs.
Q.5. According to a Mortgage Bankers Association survey, 10
percent of mortgages backed by the Federal Housing
Administration are now 30 or more days delinquent. An article
in the June 12 New York Times stated, ``The mortgage problems
underscore one main reason many policymakers and economists are
so concerned about whether the United States will enter a
recession this year.'' Can you please tell the Committee your
thoughts and concerns about the high level of mortgage
delinquency?
A.5. The national banking system had $457.3 billion of loans
secured by 1-4 family residential mortgages as of the end of
first quarter 2001. These accounted for 20.3 percent of total
national bank loans, and included a wide variety of residential
mortgage loans, including FHA loans. The noncurrent loan ratio
for loans secured by 1 to 4 family residential mortgages in the
national banking system has remained less than 1.2 percent
since year end 1994. This level of delinquency is manageable
relative to banks' capital and loan allowances. The ratio of
charge-offs for 1 to 4 family residential mortgages was 0.14
percent at the end of first quarter 2001, and for the last 10
years has remained under the .27 percent peak experienced in
1992. The housing market has been fairly resilient to the most
recent economic developments, but is vulnerable to a more
protracted slowdown.
Q.6. I have heard from varying persons that the banking
industry has significant exposure in the telecommunications
sector. What is the direct and indirect exposure to the fallout
in the telecommunications sector?
A.6. The primary source of data for industry exposures is the
Shared National Credit \1\ (SNC) data. The processing of the
SNC data for 2001 is still underway, but preliminary data
indicate telecom commitments of $130 billion with outstandings
of $49 billion. Because many nonbanks banks (that is loan
funds, insurance companies, and mutual funds) hold the majority
of the lower tranches of these credits, the exposure to the
banking industry will be significantly lower than the reported
SNC totals. By the same token, banks have direct and indirect
exposure to the telecommunications industry that are not
captured in the SNC data.
---------------------------------------------------------------------------
\1\ Shared national credits are loans extended to a borrower of $20
million or greater that are shared by three or more unaffiliated,
supervised institutions. They are reviewed annually in May and June by
teams of interagency examiners.
---------------------------------------------------------------------------
Telecommunication credits are primarily held by a few of
the largest banks, but they generally do not constitute
significant concentrations for these institutions. These
institutions typically have appropriate risk-management
processes and reserving methodologies. Their problem loan
identification has improved in the past year and their loan
loss provisions have kept pace with charge-offs.
Q.7. According to the OCC, consumers are more highly leveraged
now than at any measured point in history. Not only are debt
service payments at historical highs, but also the increase in
debt has been financed through instruments other than
mortgages. Credit card debt is rising very rapidly; the Chicago
Sun-Times reported that the average credit card debt per
household is $8,123 and has grown threefold over the past
decade. Debt service payments constitute over 14 percent of
disposable income. What do you believe the effects of this high
level of personal debt will be with regard to consumers, the
banking sector, and the economy as a whole. If the economic
downturn is worse than expected, what would be the effect of
having many people so highly leveraged?
A.7. Although the credit quality of loans to individuals has
generally not shown signs of stress comparable to that for
business lending, pressure is also increasing on the consumer.
During the period 1986 to 1992, consumer debt obligations
declined because of the refinancing boom that enabled consumers
to pay down some of their higher cost debt with income
available from refinancing. Today, both mortgage debt and other
consumer debt are rising. Despite the refinancing boom over the
last 6 months, some consumers have reloaded their credit card
and installment debt. These individuals will have a difficult
time servicing their higher debt levels if they are faced with
adverse circumstances such as rising energy costs, or less
favorable income levels in the event of job changes, and/or
layoffs in a slowing economy.
The recent sharp increases in personal bankruptcies are in
part linked to high consumer debt burdens coupled with a
slowing economy. Many analysts project bankruptcy filings to
continue to be high throughout 2001. The volume of personal
bankruptcies has a direct impact on the level of losses in
consumer loan portfolios, particularly for unsecured loans. In
this environment, some banks' credit card portfolios are
experiencing higher loss rates, though they remain within
historical norms. While bank losses for consumer loans remain
modest, if there is a prolonged slowdown and localized areas
experience layoffs, rising levels of noncurrent loans and
increased charge-offs related to banks' consumer portfolios are
likely. Overall, while the performance trends of consumer
portfolios recently turned negative, the quality of consumer
loans in the national banking system remains relatively stable.
Q.8. Remittances are a large and growing economic reality that
affect millions of people both in America and south of the
border. It has recently come to my attention that this
industry, which recent estimates have put at more than $20
billion annually, often charges high fees and that many of the
leading companies have been challenged in court for having
hidden fees. In a New York Times article it is stated that
``the fees have run from about 10 percent to 25 percent or
more.'' Do you believe that there are problems in the manner in
which the bulk of remittances are made today? What steps has
your agency taken to analyze possible solutions including
fostering or creating alternative transfer mechanisms?
A.8. Remittance services are often provided without complete
information on the total costs incurred for the service. The
total costs for international remittances may include both
explicit fees, as well as an exchange rate for the foreign
local currency that is disbursed from the amount sent in U.S.
dollars. This exchange rate may not be favorable relative to
market rates, and is often not explicitly disclosed to the
customer.
The OCC recognizes the importance of this issue, as well as
the many questions that would need to be answered before an
effective policy response could be developed. The agency would
welcome the opportunity to work with other Federal bank
regulatory agencies to discuss possible solutions.
Q.9. Former Treasury Secretary Summers has stated that ``all
high school students should receive a financial education'' and
that ``though personal financial education must begin in the
home, it must continue in the schools.'' Can you please comment
on the state of financial literacy and education among
Americans, including any deficiency in this area that should be
addressed? If you see any deficiencies, what do you believe can
and should be done with regard to these deficiencies in both a
broad sense and with regard to your agency? At the hearing I
asked for information regarding any initiatives that your
agency has taken, including the Money Smart program. Could you
please provide this information in your submission to the
record?
A.9. While most individuals continue to enjoy the benefits of
the longest period of sustained economic growth in the United
States, a sizable portion of the U.S. population remains on the
fringes of the banking system. According to the 1998 Survey of
Consumer Finances published by the Federal Reserve Board, 10
percent of U.S. households do not have a depository account
with a financial institution. Additionally, the number of
check-cashing stores continues to rise, while the national
savings rate has fallen to the lowest level in recent history.
Concerns regarding abusive lending practices also indicate a
need for consumer education.
Recent surveys suggest that financial literacy is low among
the American population as a whole, and especially low among
young people. A 2000 survey conducted by the JumpStart
Coalition for Personal Financial Literacy found that most high
school seniors failed a test of basic financial subjects
involving questions on banking products, credit cards, taxes,
savings, and investments.
In order to encourage bank participation in financial
literacy initiatives, the OCC issued an Advisory Letter AL
2001-1 on January 16, 2001 (available on the OCC website at
www.occ.treas.gov/issuances). This guidance provides national
banks with information on the types of financial literacy
programs that have been undertaken by banks and aspects of
those programs that have been most important to their success.
Released in conjunction with the advisory letter, the OCC
maintains a resource directory available on the OCC website at
www.occ.treas.gov/cdd/commfoc.htm that provides information
about programs and initiatives that span the lifecycle from
youth to retirement and illustrate the categories of financial
literacy activities described in the advisory.
Also, the OCC is one of only four Federal agencies to have
entered into a partnership with the National Academy
Foundation, a nonprofit organization dedicated to supporting
the development of the country's young people toward personal
and professional success. Our partnership with NAF has centered
on its Academy of Finance, which aims to promote financial
literacy among high school students and helps to prepare those
students for further education and careers in the financial
services field. Most recently, OCC staff have undertaken a
comprehensive revision of the Academy's course in Banking and
Credit, to ensure that the material being taught to students in
the NAF program is accurate and up-to-date.
The banking agencies recognize the impact of financial
literacy programs through the Community Reinvestment Act. Bank
participation in financial literacy programs that target both
low- and moderate-income individuals can be structured to
receive positive
consideration under the lending, investment, and service tests
of the Community Reinvestment Act.
The Money Smart program mentioned in the question is a
joint initiative of the FDIC and the Department of Labor. The
Money Smart program provides a comprehensive adult financial
education curriculum at centers nationwide that offer
employment and training services. Banks and other institutions
can also use this curriculum to serve their communities. This
type of initiative supports the goals of expanding financial
education for consumers.
Q.10. What steps has the Federal Reserve taken to promote
technology and innovation in the payments system, and what
steps should it take? As well, are you concerned that the
initiation of payments on the Internet, or through other
electronic means, could affect the safe operation of the
payments system? Note that the first part of this question is
directed at the Federal Reserve System, thus the OCC response
will speak only to the bolded section of the question.
A.10. OCC as supervisor for national banks examines those risks
associated with national bank participation in the payments
system, and takes actions as appropriate to ensure that banks
conduct these activities in a safe and sound manner. The OCC is
concerned about some specific issues that relate to Internet
payments. One such issue is authentication. Confirming the
identity of customers online is an issue with which the
financial services industry is struggling. The OCC participated
in a FFIEC Symposium on this topic in March, and will
participate in the development of FFIEC guidance on electronic
authentication.
In addition, the OCC recently issued guidance to national
banks on complying with the new rules issued by the National
Automated Clearing House Association (NACHA) on certain
Internet-initiated automated clearing house payments. These
important new rules are designed to reduce fraud by increasing
the responsibilities of companies that enable customers to
direct Internet payments through the Automated Clearing House
(ACH) network. The OCC issued Advisory Letter 2001-3 in January
to alert national banks to this rule change and will soon issue
examination procedures.
The OCC is seeking to eliminate some of the uncertainty for
national banks that exists in electronic banking activities,
including payments. On a case-by-case basis, the OCC has
authorized a number of activities in national banks including
electronic bill payment and presentment and online merchant
processing of credit card transactions. (These and other
related decisions are posted on the OCC website
www.occ.treas.gov). To further codify these and other positions
that OCC has taken with regard to electronic banking, on July
3, 2001 the OCC published a proposed rule that would provide
simpler and clearer guidance for electronic and developing
technologies activities www.occ.treas.gov/01rellst.htm.
Q.11. Comptroller Hawke, at a speech you gave on December 2,
1999, you talked about privacy and consumers' interest in
controlling the sharing of their personal confidential
financial data with other companies for unintended purposes.
You said, ``The industry's argument was that to allow customers
to prevent banks from sharing confidential customer information
with their affiliates would destroy the synergies and
efficiencies that would be made possible by the new law. I do
not accept this argument . . .'' It should not be assumed that
customers will automatically opt out. If banks and other
financial firms really have something to offer customers, they
should be able to convince them not to opt out--that
information sharing is really in their interest, if that is in
fact the case. There is a certain patronizing quality in the
argument that we should not allow customers to opt out because
we really know what is best for them. Do you feel the synergies
from the Gramm-Leach-Bliley Act can coexist with allowing
customers to control the sharing of their information with
affiliates?
A.11. Consumers already possess the ability to direct financial
institutions not to share certain confidential information
about them with affiliates under the Fair Credit Reporting Act.
This opt out right pertains to consumer reporting information,
such as application information that relates to a consumer's
creditworthiness. There is no current evidence that this opt
out right has harmed the business opportunities among
affiliated financial institutions. Of course, affiliated
companies must remain free to disclose customer information to
one another in order to service or process a transaction that a
consumer initiates. This type of information disclosure is
consistent with that permitted between nonaffiliated third
parties under the Gramm-Leach-Bliley Act (GLBA). Providing
consumers with the ability to opt out of information
disclosures among affiliated companies for marketing, however,
would not appear to destroy potential synergies among the
companies. Based on the rate of opt outs under both the FCRA
and the GLBA, thus far, an assumption that customers will
automatically opt out of affiliate information sharing would
appear to be erroneous.
Q.12. On September 16, 1997, a Subcommittee of the Senate
Banking Committee, chaired by Senator Bennett, held an
important hearing on the issue of identity theft, which occurs
when someone uses the personal information of another person to
obtain credit cards or other financial instruments or assets.
Just a few weeks ago, The Washington Post published an article
by Robert O'Harrow which observed that ``the Justice Department
says that `identity theft is one of the Nation's fastest
growing white-collar crimes.' '' How prevalent is this crime?
What is its impact on bank customers and on banks? What efforts
are being taken to end this practice?
A.12. The OCC does not have independent statistics about the
prevalence of identity theft. However, there has been a
significant increase in the incidence of identity theft
reported in Suspicious Activity Reports (SAR's). SAR statistics
compiled by FinCEN indicate that the number of reported
incidents of identity theft increased from 44 in 1997 to 617 in
the first 11 months of 2000. There are 1,030 SAR's in the
system reporting identity theft and this number is likely to
grow, especially in light of a recent OCC advisory letter to
national banks on identity theft and pretext calling, that
instructed banks specifically how to report incidents of
suspected identity theft and pretext calling on a SAR.
This year, the OCC's Consumer Assistance Group received 105
complaints involving identity theft. Seventy-eight complaints
involved credit card accounts and 27 related to checking
accounts. However, the FTC's identity theft hotline receives
thousands of calls each week. Half of the complaints the FTC
has been receiving involve credit card fraud. Figures are not
available with respect to losses to banks or their customers as
a result of identity theft. However, identity theft does result
in monetary losses to both bank customers and the institutions
themselves. Under Regulation Z, in instances involving identity
theft, a consumer could incur liability for the unauthorized
use of the consumer's credit card account up to $50. The card
issuer is responsible for the remaining losses to the consumer.
Under Regulation E, a consumer's liability for unauthorized
electronic fund transfers involving his or her account varies
depending upon the precise circumstances of the unauthorized
use and the consumer's timeliness in reporting unauthorized
transactions or the loss or theft of an access card, number, or
other
device. Where a consumer acts promptly upon discovering an
unauthorized transaction, in most circumstances the bank will
be responsible for the total amount of any such transaction.
As mentioned above, in April, the OCC issued Advisory
Letter 2001-4 to increase banks' awareness in regards to
identity theft and pretext calling and encourage banks to take
specific measures to protect their customers against these
types of fraud. The letter informs banks about safeguards to
prevent identity theft--such as verification procedures for new
customer accounts, verification of change of address requests,
and implementation of the new interagency security standards.
The advisory letter also encourages banks to educate their
customers about ways to prevent identity theft and pretext
calling and to assist those customers who may have been the
victims of such fraud. The advisory directs banks to a consumer
brochure on the OCC's website (www.occ.treas.gov/idtheft.pdf)
on identity theft and pretext calling that banks may download
and provide to their customers.
Q.13.a. According to the Japanese banking industry's own
publicly disclosed numbers, about 30 percent of bank assets are
classified by examiners as having problems. Experience in the
United States and other industrialized countries indicates that
if a bank has classified assets of 10 percent to 15 percent of
total assets, it is in danger of becoming insolvent and needs
immediate supervisory action. The Finance Minister of Japan is
reported to have said a few months ago that ``Japan's fiscal
situation is at the verge of collapse.'' Data from various
official and academic sources indicate Japan's government debt
is well over 100 percent of GDP and growing rapidly, and some
experts believe Japan is reaching its financing limits. What is
your assessment of the Japanese banking system?
A.13.a. The Japanese banking system remains in poor condition.
While the infusion of public money relieved some of the
pressure from the 1998 crisis and reduced systemic risk, the
resolution of bad assets has not been completed. In general,
banks' earnings are weak. As domestic and global economic
conditions slow, the health of the banking sector may worsen.
Additionally, the decline in Japan's stock markets combined
with the application of more stringent mark-to-market
accounting standards limits the banks' gains from sizable
equity holdings, which have been a recurring source of
significant income in the past.
Q.13.b. What risk, if any, does the situation in Japan pose to
both U.S. financial institutions and to the U.S. economy?
A.13.b. Japan holds among the largest foreign exchange reserves
in the world thereby mitigating transfer risks to U.S.
financial institutions. But over the past decade of Japan's
economic stagnation, U.S. financial institutions have been
subject to increased credit risks on Japanese exposures. As a
result, U.S. banks have reduced their Japan exposures from the
peak of $103.5 billion at year end 1998 to $83.8 billion at
year end 2000. About 54 percent of Japanese exposures are
cross-border claims while the rest are booked in the Japanese
offices of U.S. banks.
Japan's economy is important to the United States and
global economies and financial markets. For many Southeast
Asian countries, Japan is a major export market, investor, and,
in certain industries, a competitor. Continued economic
weakness in Japan can be expected to reduce growth and put
downward pressure on currencies throughout Southeast Asia.
Potential effects on the U.S. economy are not expected to be
severe. But Japan is the third biggest market for U.S. exports
and a major source of investment in U.S. markets, so the
effects will be a factor for the U.S. economic markets. If
Japan faces a liquidity crisis due to financial system
weaknesses, Japanese investors may turn to their investments in
the United States as a source of funds. Taken together,
financial turmoil in Japan has the possibility of increasing
volatility in U.S. debt and equity markets. The OCC maintains
ongoing contact with Japanese bank supervisors, including
periodic meetings with senior officials of the Financial
Services Agency to regularly assess these potential
developments.
Q.13.c. What actions should be taken to improve it?
A.13.c. Japan's economic and financial sector problems are deep
rooted and require a comprehensive approach on a variety of
fronts. Recently, the government outlined a series of steps,
with one high priority the resolution of the bad loan problem.
Effective follow-through on the stated priorities is essential
to the recovery of the Japanese economy.
In recent years, the Japanese authorities have made
progress in improving bank supervision. They established the
Financial Services Agency (FSA) as the key financial services
regulator, and they are building a more risk-focused
supervisory function. U.S. regulatory agencies will continue to
work with the FSA staff to promote a more effective global
supervisory process.
Q.14. There have been reports that Argentina is facing serious
economic peril. What can you tell us on the situation in
Argentina? What effect, if any, do you see on the United
States' economy as a whole, and specifically on the financial
sector?
A.14. The Argentine government remains in a difficult situation
as it tries to revitalize its economy. Argentina has been mired
in a domestic confidence problem, which has slowed tax revenues
causing the government's fiscal deficit to escalate and
investors to question whether the government could meet its
debt payments. This concern is resurfacing, despite a
restructuring of a significant amount of debt, as high-interest
rates compound Argentina's debt servicing requirements.
U.S. national bank exposure is within reasonable bounds.
Naturally, U.S. banks may experience some credit problems with
their exposures, but U.S. banks generally have had sufficient
time to position themselves to limit the effects from a full-
fledged crisis. With respect to the U.S. economy overall,
Argentina's recession and turbulence have not affected the
United States to any significant degree as trade with Argentina
is less than 1 percent of U.S. exports. The OCC continues to
closely monitor developments in Argentina, as well as contagion
and spill over effects, and the implications for the national
banking system.
Q.15. Another disparity involves rules on loans to one
borrower. National banks are generally allowed to lend no more
than 15 percent of their capital on an unsecured basis to a
single borrower. Many States have higher limits for the banks
they charter. On June 8, 2001, the OCC announced a new pilot
program allowing national banks with the highest supervisory
rating to lend up to the State limit--but no more than 25
percent of capital--to single borrowers under certain
circumstances. Please describe the competitive regulatory
disparity that led the OCC to implement this pilot program.
A.15. As a routine and ongoing part of our supervisory
activities, representatives of the OCC conduct outreach
meetings with bankers in various settings across the country.
During these meetings, bankers in States with higher legal
lending limits indicate that this disparity in the amount of
credit they are permitted to advance to one borrower puts them
at a competitive disadvantage with State chartered banks. This
is because they are not able to provide the level of services
to some of their best customers that similar size State banks
can provide. It is also viewed by many banks as a burden issue
because if they want to make such loans they must find other
banks to participate if they are to retain the lending
relationship. Bankers also view this as a loss of potential
loan income at a time when earnings trends are declining.
There are 25 States that have a lending limit for unsecured
loans that is higher than the national bank lending limits.
This pilot program allows eligible banks in those States with
higher lending limits to make loans up to the State limits for
residential loans secured by real estate and for unsecured
small business loans. This program is only available to
eligible banks, for example, they must be rated at least a
composite ``2,'' the management and asset quality components
must be rated ``1'' or ``2,'' and their participation is also
subject to approval by their supervisory office. Also, at the
discretion of the supervisory office, their authority under
this program may be withdrawn at any time.
Q.16. In a speech before the American Bankers Association,
Federal Reserve Board of Governors Member Edward Gramlich said
that, ``Higher rates of national savings are among the unsung
heroes of good U.S. economic performance in the late 1990's.''
But the most recent data from the White House shows a
substantial decline in personal savings, from over 5 percent in
1996 to minus 0.9 percent today. Do you think that this is a
serious problem, and if so, what can we do to ameliorate it?
What position does this place Americans in if the economic
slowdown worsens? What are the effects of this decline with
respect to national investment levels and GDP growth?
A.16. The drop in the reported personal savings rate over the
last 5 years from 5 percent to 0.9 percent provides a distorted
measure of household finances and households' ability to
continue spending. The reported savings rate as calculated from
the National Income and Product Accounts (NIPA) is calculated
as disposable personal income less personal outlays, as a
percent of disposable income. The NIPA disposable income
measure, however, understates household resources available for
spending because it focuses on production and does not include
realized or unrealized gains or losses from the sale of
nonproduced assets, such as land or financial assets (stocks
and bonds). Researchers at the Federal Reserve Bank of New York
\2\ have constructed a more meaningful measure of personal
savings including capital gains. The results of their study
indicate that the personal savings rate and the resources
available to households for spending have not declined over the
last 5 years. Thus, the reported personal savings rate may not
fully reflect the financial position of households, and may
mask the true increase in national savings referred to by
Federal Reserve Board Governor Gramlich.
---------------------------------------------------------------------------
\2\ Peach, Richard, and Charles Steindel. ``A Nation of
Spendthrifts? An Analysis of Trends in Personal and Gross Saving,''
Current Issues in Economics and Finance, Federal Reserve Bank of New
York, Volume 6, Number 10 (September 2000).
Q.17.a. What forms, if any, of bank surveillance are done
---------------------------------------------------------------------------
through automated technology and/or the Internet?
A.17.a. The OCC has various automated systems to monitor the
safety and soundness of the national banking system. This
information is used on an individual bank basis to enable
examiners and managers to identify potential risk areas and
better allocate resources through more focused examinations.
The following highlights both longstanding, as well as recently
developed systems:
Uniform Bank Performance Reports
For the past two decades, staff at the OCC and other bank
regulatory agencies have used the Uniform Bank Performance
Report (UBPR) to monitor the condition of the banking system as
well as perform analysis on individual banks. The UBPR packages
a large amount of data covering balance sheet, income statement
and off balance sheet components into an information oriented
format that enables supervisors to evaluate bank specific risk
profiles and growth trends, as well as comparisons to peer
groups. Supervisory staff also has the ability to develop
customized peer groups for banks with unique characteristics
and in specific geographic areas.
Canary System
Canary is an automated early warning system designed to
identify community and mid-size banks that may have high or
increasing quantities of credit, liquidity or interest rate.
Canary uses a combination of internal and external models that
evaluate a bank's prospective profitability, as well as the
probability of a bank becoming severely troubled under a
variety of economic scenarios. The system also is used to
identify banks designated as low risk. These are institutions
with a low financial risk profile that are subject to
streamlined supervision. Canary also facilitates the analysis
of trends across the banking system.
Financial Market Information
The OCC tracks broad financial market information on the
banking system as a whole, as well as individual banks.
Information gleaned from the Internet, Bloomberg Analytics,
Moody's Structured Finance DataBase, and the proprietary data
bases of various research firms complement the onsite, bank
specific information provided by OCC examiners. In addition to
regular news flow on general matters, financial and commodity
prices, the OCC tracks specific bank equity, debt, and asset-
backed securities to evaluate current and changing market
perceptions.
Examiner View
Examiner View (EV) is the supervisory information system
used by all examiners who supervise mid-size and community
banks, Federal branches and agencies, and technology service
providers, to input examination information into a centralized
database via personal computers. The system helps the
supervisory process by facilitating the prompt and consistent
aggregation of data.
Q.17.b. Does your agency have any plans to augment the role of
automated technology in gathering and disseminating
information?
A.17.b. The OCC will continually enhance various reporting
features of Canary and Examiner View. Enhancements will
facilitate more focused analyses of banks of varying sizes and
business activities. Upgrades will also enable more efficient
supervisory planning and allocation of resources.
The OCC's Supervision in the Future project is underway to
prepare the OCC for the demands of future bank supervision. The
goals of this project are to leverage computer and
telecommunications technology, and ultimately to use leading
edge risk analysis methods to improve the efficiency and
effectiveness of the bank supervision process. One pilot
project under this broader program is the development of a
common file format for loan data that will provide more highly
automated support technology to the credit review aspect of the
examination process. If the pilot project is deemed successful,
this type of program may be expanded to other areas of the
supervision process.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES FROM DONNA
TANOUE
Q.1. What do you think is the single greatest potential problem
that is facing the United States financial system today?
A.1. Over the short run, the greatest concern is declining
commercial credit quality. With problem loans rising and with
this trend expected to continue, a downturn in economic
activity could pose significant problems for some banking
institutions.
In addition to concerns about credit quality, the flaws in
the current deposit insurance system represent significant
problems that should be addressed. The current system
exacerbates downturns by requiring the highest premiums when
banks can least afford to pay, underprices risk in general and
subsidizes higher-risk institutions in particular, and
allocates the assessment burden unfairly.
Over the longer run, industry consolidation presents
concerns. The risk exposure of the deposit insurance funds is
increasingly concentrated in relatively few large institutions.
As these institutions continue to grow and their activities
become more complex, this poses challenges to bank regulators
in terms of monitoring and understanding the risk exposures of
these institutions appropriately and devising effective
supervisory approaches.
Q.2. While many analysts predict a recovery from the current
economic slowdown in the second half of the year, there is
still a chance that the downturn could be worse than expected.
If the economy were to perform below expectations, what
consequences would that have for the safety and the soundness
of the banking system?
Specifically, I would like to ask about the banking
system's risk exposure in the following areas:
Noncurrent Loans
Credit Card and Consumer Loans
Mortgage Delinquencies
Telecommunications Sector
A.2. The ratio of noncurrent loans to total loans is steadily
rising. The ratio has edged up to 1.12 percent in the first
quarter of 2001 from 0.92 percent one year earlier. In spite of
this increase, the banking industry as a whole is in much
better shape than it was during the last downturn. Noncurrent
loans represented 3.25 percent of total loans--nearly three
times higher than the current ratio--when the U.S. economy
entered the last recession in 1990.
The credit quality of credit card and consumer loans has
deteriorated somewhat in the past 2 quarters. The ratio of
noncurrent credit card and consumer loans has edged up in the
first quarter of 2001 and the net charge-off rate for credit
card and consumer loans has also risen in the past 2 quarters.
The rapid rise in consumer credit and indebtedness in recent
years may cause the credit quality of credit card and consumer
loans to deteriorate quicker in the case of further weakening
in economic conditions. Net charge-off rates for credit card
and consumer loans were considerably higher in the first
quarter of 2001 than they were at the onset of the last
recession.
Overall, the mortgage delinquency rate has been relatively
stable in the past few quarters. According to Standard and
Poor's, 90 day delinquencies of prime and subprime residential
mortgage-backed securities have shown little increase in the
early months of 2001.\1\ However, mortgage delinquencies may
rise, particularly among subprime mortgage loans, if the
economy weakens further. Amid the weakening economy and rising
layoffs, the percentage of noncurrent FHA and VA loans has
risen sharply in recent months (see enclosed chart).
---------------------------------------------------------------------------
\1\ Standard and Poors, ``All Flat on the Housing Front,'' Ratings
Commentary, June 15, 2001.
---------------------------------------------------------------------------
The banking industry has significant exposure to the
telecommunications sector from their syndicated lending
activities. Regulators continue to work together and monitor
banks' exposure to the sector through the Shared National
Credit (SNC) review. The SNC data are obtained from the
confidential onsite examination process. Should the Committee
require more information about the result, it would be best
handled through a confidential briefing by the appropriate
regulator.
Q.3. After 5 very good years, the rate of nonperforming
commercial, industrial, and personal loans increased by 26.6
percent in 2000. Can you please tell me what stress, if any,
this places on the banking system, and whether or not you
expect a similar rate of increase for this current year?
A.3. Although nonperforming loans have recently risen at a high
percentage rate, they remain relatively low as a percent of
total loans outstanding (1.12 percent as of March 2001).
Analysts generally agree that the increases in
nonperforming loans during 2000 were the result of relatively
weak loan underwriting in the late 1990's, a slowing U.S.
economy, and the well-publicized problems that have affected
certain industry sectors. These conditions are likely to
contribute to the emergence of additional problem loans during
the remainder of 2001. As a result, commercial loan losses are
likely to rise further before stabilizing. Recent indicators
show that consumer loan losses also are likely to rise in 2001,
with their ultimate level depending on how the U.S. economy
fares over the remainder of the year.
Although it appears likely that nonperforming bank loans
will again rise at a double-digit rate in 2001, they also are
likely to remain at manageable levels for the vast majority of
insured institutions. At the end of 2000, less than 1 percent
of insured institutions carried noncurrent loans (90 days or
more past due plus nonaccrual) greater than 6.0 percent of
total loans. As recently as 1991, almost 7 percent of insured
institutions carried noncurrent loans above the 6.0 percent
threshold.
Q.4. Though the delinquency rates for credit card and consumer
loans are well below the high levels experienced during the
last economic downturn, they have risen back to levels
comparable to 1993. What do you think the effects of this
increase in delinquency rates will be, with regard to both
consumers and the financial institutions that you regulate?
A.4. With the exception of credit card lending, consumer loans
have traditionally been one of the best-performing loan
categories on bank balance sheets. Charge-off rates on credit
card loans at FDIC-insured institutions remain high, which has
helped to drive the aggregate consumer loan charge-off rate
higher. Despite the higher charge-offs, most consumer lenders,
and in particular credit card lenders, have developed
sophisticated risk-management practices that have enabled them
to enhance profitability in a higher-loss environment. However,
insured institutions also have increased activity in the
subprime consumer lending market, which has not yet been tested
in an economic downturn. While it is unlikely that a
significant number of institutions would fail due solely to
problem consumer loans, consumer lenders and current risk-
management practices potentially could face a much tougher
earnings environment if the economy should slow significantly.
Q.5. According to a Mortgage Bankers Association survey, 10
percent of mortgages backed by the Federal Housing
Administration are now 30 or more days delinquent. An article
in the June 12 New York Times stated, ``The mortgage problems
underscore one main reason many policymakers and economists are
so concerned about whether the United States will enter a
recession this year.'' Can you please tell the Committee your
thoughts and concerns about the high level of mortgage
delinquency?
A.5. The rise in delinquencies on mortgages backed by the
Federal Housing Administration (FHA) reflects a potential rise
in problem mortgage loans made to financially leveraged
consumers. Past due FHA loans rose to an historical high of
11.2 percent in the fourth quarter of 2000. In contrast, past
due conventional loans rose to only 3.1 percent, well below the
4.3 percent past due rate recorded in the fourth quarter of
1985. Problems in FHA backed mortgages are likely to appear
more quickly than in conventional mortgages because FHA
borrowers also are likely to experience financial problems more
quickly if economic conditions deteriorate and the labor market
weakens significantly.
Q.6. I have heard from varying persons that the banking
industry has significant exposure in the telecommunications
sector. What is the direct and indirect exposure of banks to
the fall-out in the telecommunications sector?
A.6. As noted in Answer 2, the banking industry has significant
exposure to the telecommunications sector from their syndicated
lending activities. Regulators continue to work together and
monitor banks' exposure to the sector through the Shared
National Credit (SNC) review. The SNC data are obtained from
the confidential onsite examination process. Should the
Committee require more information about the result, it would
be best handled through a confidential briefing by the
appropriate regulator.
Q.7. According to the OCC, consumers are more highly leveraged
now than at any measured point in history. Not only are debt
service payments at historic highs, but the increase in debt
has been financed through instruments other than mortgages.
Credit card debt is rising very rapidly; the Chicago Sun-Times
reported that the average credit card debt per household is
$8,123 and has grown threefold over the past decade. Debt
service payments constitute over 14 percent of disposable
income. What do you believe the effects of this high level of
personal debt will be with regard to consumers, the banking
sector, and the economy as a whole? If the economic downturn is
worse than expected, what would be the effect of having so many
people so highly leveraged?
A.7. Highly indebted consumers could be at high risk in a
slower growing economy. As income growth slows and unemployment
rises, these consumers will find it more difficult to service
mounting debts. Possible negative effects could include rising
consumer bankruptcies, rising consumer loan charge-offs, and
reduced consumer spending that could exacerbate an already
slow-growing economy. According to data from the Federal
Reserve Survey of Consumer Finances, the burden of debt service
falls disproportionately hard on families in lower income
brackets. Consumer credit problems, particularly those in
subprime loan portfolios, could also fall disproportionately
hard on consumers in these income classes. Overall, consumers
have recently assumed mortgage debt at a rapid rate. According
to data from the Federal Reserve Flow of Funds, nearly $400
billion in home mortgages was added to the balance sheet of the
household sector from year-end 1999 to year-end 2000.
Q.8. Remittances are a large and growing economic reality that
affect millions of people both in America and south of the
border. It has recently come to my attention that this
industry, which recent estimates have put at more than $20
billion annually, often charges high fees and that many of the
leading companies have been challenged in court for having
hidden fees. In a New York Times article it is stated that
``the fees have run from about 10 percent to 25 percent or
more.'' Do you believe that there are problems in the manner in
which the bulk of remittances are made today? What steps has
your agency taken to analyze possible solutions including
fostering or creating alternative transfer mechanisms?
A.8. We are not aware of major problems within the banking
industry relative to excessive fees charged for remittances.
The New York Times article referenced in the question refers to
the excessive fees paid by Mexican migrants to transfer money
back to their families in Mexico. Most of the abuses apparently
involve people without legal status to have banking or checking
accounts. The article also mentions that new wire transfer
systems are being developed that will substantially reduce the
costs of these wire transfers. Instead of the $80 to $90 fees
that apparently have been charged to some unsophisticated
customers to transfer $300 to Mexico, the new competitors are
expected to charge less than one-fourth of that amount. This
appears to be an example where the marketplace is taking proper
steps to address abuses by increasing competition.
A more recent article in the American Banker notes that a
White House task force is studying a broad array of United
States-Mexican border issues including this one. The financial
services industry should take steps to eliminate these types of
abusive practices by ensuring that consumers are well informed
and that transaction fees are fair, equitable, and fully
disclosed. The FDIC will do its part to ensure similar abuses
do not occur within the banking industry.
Q.9. Former Treasury Secretary Summers has stated that ``all
high school students should receive a financial education,''
and that ``though personal financial education must begin in
the home, it must continue in the schools.'' Can you please
comment on the state of financial literacy and education among
Americans, including any deficiency in this area that should be
addressed? If you see any deficiencies, what do you believe can
and should be done with regard to these deficiencies in both a
broad sense and with regard to your agency? At the hearing I
asked for information regarding any initiatives that your
agency has taken, including the Money Smart program. Could you
please provide this information in your submission to the
record?
A.9. Enclosed is a copy of my June 21, 2001 letter, pursuant to
my testimony, that provided information on the FDIC's Money
Smart Program. Financial literacy fosters financial stability
for individuals and entire communities. The more people know
about credit and banking services, the more likely they are to
increase savings, buy homes, and increase their financial
health and well being.
While financial literacy is a universal need, it can be
particularly critical for individuals with a modest income and
few, if any, assets. That is why the FDIC created Money Smart,
a comprehensive curriculum to help adults outside the financial
mainstream develop positive deposit and credit relationships
with commercial banks and thrifts.
The Money Smart program explains basic financial
instruments, services, and products in 10 instructor-led
training modules. The curriculum begins with an introduction to
bank services and progresses to choosing and maintaining a
checking account, budgeting and saving, the importance of
credit history, consumer rights and responsibilities, selecting
and using credit cards, understanding other forms of consumer
credit, and a very basic introduction to home ownership.
The FDIC provides the Money Smart curriculum to banks and
to other organizations interested in sponsoring financial
education workshops free-of-charge. The FDIC encourages banks
to work with others in their communities to deliver financial
education and appropriate financial services to individuals who
may be unfamiliar with the benefits of having a relationship
with an insured depository institution.
In addition, the FDIC and the Department of Labor (DOL) are
working together to promote financial education and to make
Money Smart available at employment centers, called One Stop
Centers, across the country. To facilitate use of the program,
FDIC and DOL are scheduling orientation sessions for bankers
and One Stop Centers in urban and rural locations around the
country.
Q.10. The percentage of commercial and industrial loans that
are noncurrent, that is, delinquent, has increased over the
past 3 years. Over the past year, there has been an increase in
these types of loans held by large banks, while there has not
been a similar increase among small banks. Do you think that
increased consolidation has had a negative effect on the
quality of loans held by large banks?
A.10. The decline in credit quality is attributable to a
confluence of factors. These factors include a weakening of
underwriting standards in the optimistic climate of a long run
economic boom, increasing corporate leverage, and intense
competition and earnings pressure in the financial services
sector. It is difficult to identify any independent effect of
consolidation per se on credit quality.
Q.11. Over the last decade, core deposits have declined as a
percentage of bank and thrift assets, as individuals have taken
advantage of new investment options. Declining deposits have
forced banks to look elsewhere for sources of liquidity. Small
community banks, which may have limited access to alternative
funding sources, are increasingly relying on advances from the
Federal Home Loan Banks as a way to meet their liquidity needs.
Do you have any comments on this development and its
implications, if any, for the financial services industry?
A.11. Increased reliance on liabilities other than core
deposits implies potentially higher and more volatile funding
costs for banks. However, with appropriate risk-management
practices, banks can incorporate nondeposit funding into their
business operations in a safe and sound manner. Indeed, there
is evidence that many banks are now using FHLB advances to
hedge interest-rate exposures of their longer-term assets. The
situations that have raised concerns for FDIC examiners thus
far have involved institutions with a heavy reliance on
advances and bank management that did not fully understand the
risks associated with these instruments. To address such
concerns, the FDIC issued examiner guidance for reviewing FHLB
advances late last year.
Q.12. In a speech before the American Bankers Association,
Federal Reserve Board of Governors Member Edward Gramlich said
that, ``Higher rates of national savings are among the unsung
heroes of the good U.S. economic performance in the late
1990's.'' However, the most recent data from the White House
shows a substantial decline in personal savings, from over 5
percent in 1996 to minus 0.9 percent today. Do you think that
this is a serious problem, and if so, what can we do to
ameliorate it? What position does this place Americans in if
the economic slowdown worsens? Finally, what are the effects of
this decline with respect to national investment levels and GDP
growth?
A.12. Many policymakers and analysts have expressed concerns
about the sharp decline in personal savings rate in recent
years. Related to this decline in personal savings are concerns
about an increasing level of household debt and reliance on
foreign capital to fuel domestic investment in the short term,
as well as longer-term concerns about the adequacy of
retirement savings. However, the seriousness of this problem
may depend on how well the official personal savings rate
captures actual changes in household savings. Some analysts
argue that the official personal savings rate significantly
understates household savings because of its inconsistent
treatment of durable goods, payments from corporations,
inflation, and taxes, as well as its exclusion of capital
gains.\2\
---------------------------------------------------------------------------
\2\ William G. Gale, ``A Crisis in Saving?'' Barrons, August 16,
1999; Eric M. Engen, William G. Gale and Cori E. Ucello, ``The Adequacy
of Household Saving,'' The Brookings Institute Working Paper, January
2000; William G. Gale and John Sabelhaus, ``Perspectives on the
Household Saving Rate,'' Brookings Papers on Economic Activity 1, 1999.
---------------------------------------------------------------------------
However, the rising household debt level does raise
concerns, particularly in times of an uncertain economic
environment. In spite of lower interest rates, if the economy
worsens with continued layoffs and a decline in personal
income, households are likely to face an increase in the debt
service burden, which is already near its historical high. From
a macroeconomic perspective, robust consumer expenditures and
corporate investment that accompanied the decline in personal
savings were important contributing factors behind robust GDP
growth in the past few years. Both consumer expenditures and
corporate investment were funded mainly by government surplus
and foreign capital. Foreign capital inflows have continued in
recent months in spite of signs of a sharp slowdown in the U.S.
economy. However, if the economic situation worsens, foreign
capital inflows to the United States could drop significantly,
having an adverse effect on consumption and investment.
Q.13. What steps has the Federal Reserve taken to promote
technology and innovation in the payments system, and what
steps should it take? As well, are you concerned that the
initiation of payments on the Internet, or through another
electronic means, could affect the safe operation of the
payment system?
A.13. By issuing guidance that is technology neutral, the
Federal regulators have sought to foster innovations such as
Internet banking and Internet-initiated payments. The Federal
Reserve has taken a number of steps to promote technology and
innovation in the payments system. For example, the Federal
Reserve Board recently requested comment on five interim rules
to establish uniform standards for the electronic delivery of
notices to consumers, namely: Regulations B (Equal Credit
Opportunity); E (Electronic Fund Transfers); M (Consumer
Leasing); Z (Truth in Lending); and DD (Truth in Savings).
Also, on May 16, the Federal Reserve requested comment on how
the Board's regulations may be adapted to online banking and
lending.
The FDIC has also taken a number of steps to promote
technology and innovation in financial services and was one of
the first bank regulators to provide guidance to the industry
on issues related to technology and payment systems. The FDIC
has issued more than 20 guidance documents pertaining to topics
such as Internet banking and payments. Furthermore, to ensure
that the opportunities and risks associated with technology are
monitored and responded to a Bank Technology Group was created
within the Chairman's Office. An important example of steps
that the FDIC has taken to promote the safe use of information
technology in banking is the Security Standards for Customer
Information issued in March 2001. The FDIC worked with the
other Federal financial institution regulators to develop the
standards, as required by Section 501 (b) of the Gramm-Leach-
Bliley Act. The standards were crafted to be technology-neutral
so as not to inhibit innovation. The FDIC continues to work
closely with the industry and with other Federal and State
regulators to ensure that safety and soundness is preserved in
this increasingly networked environment.
As a public network, the Internet is inherently less secure
than the traditional payment networks that preceded it. As
financial institutions connect to the Internet and permit
payments to be initiated over this channel, additional security
measures are necessary. The FDIC is committed to monitoring new
developments in technology and related risks to the banking and
payment systems. Through supervisory processes, guidance, and
education, we will continue to emphasize to the industry the
importance of security and effective controls.
Q.14.a. What forms, if any, of bank surveillance are done
through automated technology and/or the Internet?
A.14.a. All insured depository institutions are required to
file consolidated Reports of Condition and Income (Call
Reports) on a quarterly basis in an electronic format. The
information is extensively used by the bank regulatory agencies
in their daily offsite bank monitoring activities. Call Report
data also is used by the public, the Congress, State banking
authorities, researchers, bank rating agencies, and the
academic community. The FDIC is fully responsible for
maintaining an accurate and up-to-date Call Report database
readily available to all users through the Internet. The FDIC
uses the data collected in the Call Reports most extensively
for supervisory/surveillance purposes in an effort to detect
emerging risks. The FDIC has several surveillance programs and
early warning models it uses to achieve these objectives.
The offsite systems are designed to support FDIC's
examination and risk assessment functions by identifying
potential downgrades of CAMELS ``1'' and ``2'' rated
institutions, flagging institutions with high-risk profiles, or
calculating capital requirements for institutions projected to
fail in the short term. The three primary offsite models used
by the FDIC Division of Supervision (DOS) are Statistical
CAMELS Offsite Rating system (SCOR), Growth Monitoring System
(GMS), and Real Estate Stress Test (REST).
Statistical CAMELS Offsite Rating (SCOR)
In the mid-1990's, the FDIC developed an offsite rating
tool called SCOR to more effectively and efficiently monitor
risk to the banking and thrift system. SCOR uses Call Report
data to identify institutions likely to receive a rating
downgrade at their next examination. The system uses
sophisticated statistical techniques to estimate the
relationship between Call Report/Thrift Financial Report data
and examination results. SCOR is available to FDIC supervisory
personnel on the FDICnet and to other regulators, including
State banking authorities, through the Extranet.
Growth Monitoring System (GMS)
GMS is an offsite rating tool that effectively and
efficiently identifies institutions that have grown rapidly
and/or have a funding structure highly dependent on noncore
funding sources. GMS is a prospective model that focuses on the
relationship between loan growth and noncore funding sources.
Using statistical techniques, GMS analyzes financial ratios and
changes in dollar balances to identify banks that have
experienced rapid growth. Plans are to provide the results of
the GMS to FDIC personnel and other regulators through
automated technology being developed in the Virtual Supervisory
Information On the Net (ViSION) project.
The purpose of ViSION is to provide an integrated, state-
of-the-art technology solution to support the Division of
Supervision. ViSION will create a system that will enable DOS
staff to perform their work within an integrated system. When
completed, staff will have the ability to review, process, and
distribute examination reports, offsite analysis reports,
applications, risk-related premium assessments, and
correspondence within the system. Such a system envisions data
being manually or electronically entered into the new system
only once and electronically manipulated thereafter.
Real Estate Stress Test (REST)
REST identifies financial institutions likely to be
vulnerable to a real estate crisis similar to what occurred in
New England in the early 1990's. REST attempts to simulate what
would happen to banks today if they encountered a real estate
crisis similar to that of New England. Plans are to provide the
results of REST to FDIC personnel and other regulators through
automated technology being developed in the ViSION project.
Other offsite tools used by the FDIC include the Uniform
Bank Performance Report (UBPR) and the Large Insured Depository
Institution Program (LIDI). The UBPR is a report available to
the public on the Internet that uses the Call Report data to
provide information (ratios, percentages, and dollar amounts)
on individual bank performance. Each UBPR also includes data
for the bank's peer group averages and percentile rankings for
most ratios. The comparative and trend data contained in these
reports complement the offsite analysis process performed prior
to examinations.
The LIDI is a Division of Supervision quarterly review of
the industry's largest banks and thrifts. Its purpose is to
assist staff by culling company-specific and market information
on the largest financial entities. The information is detailed
on the LIDI web page and facilitates continuous offsite
monitoring of the largest insured financial entities. A central
component of the site is timely analytical reports prepared by
case managers of the Division of Supervision that summarize
current developments and risks facing an institution.
Q.14.b. Does your agency have any plans to augment the role of
automated technology in gathering and disseminating
information?
A.14.b. The FDIC does plan to use automated technology to
gather information about financial institutions. A future
module in ViSION known as Risk Management, will ``crawl'' other
web sites (newspapers, SEC filings, First Call, etc.) looking
for information on a regulated entity and join this information
with existing Call Report, UBPR, SCOR, GMS, and systems from
other regulators to identify increasing risk in a bank. As far
as other gathering and disseminating of information,
FDICconnect is being designed to be the business to Government
(B2G) connection where banks and other FDIC business partners
can submit information such as
applications, bills, make payments, ask questions, and receive
information such as assessment bills, exam reports, approved
applications, Financial Institution Letters. FDICconnect
recently started a pilot with 86 banks and can conduct a very
small number of transactions. FDICconnect also was initiated to
meet an Executive Order to have each agency provide an
electronic means to transact business with Government agencies
by 2002 or 2003.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES FROM ELLEN
SEIDMAN
Q.1. What do you think is the single greatest potential problem
facing the United States financial system today?
A.1. Both the nature and magnitude of risks facing the thrift
industry change over time. At this point, a shift in funding
sources away from low-cost retail deposits over the past 5 to
10 years is currently the most noticeable risk for the thrift
industry. Asset quality concerns remain subdued. However, we
continue to closely monitor asset quality trends, which are
very sensitive to changes in the U.S. economy.
Retaining low-cost stable deposits has become a challenge
for the majority of financial institutions. Competition
continues unabated. Disintermediation has forced financial
institutions to seek alternative funding sources. Wholesale
borrowings have become an increasing important source of
funding for some institutions in recent years. We are
continuously monitoring and assessing risks associated with
this trend.
As illustrated in the table below, as a percentage of all
fundings, small balance deposits have declined from 67 percent
in 1995 to 49 percent in 2000. This decline has been replaced
by increases in large balance deposits and FHLB borrowings.
There are several risks associated with the trend in
funding sources. The most serious potential risk is the
liquidity concerns that would result from any flight to quality
crisis. A significant negative financial or economic event
could cause investors to move money into safe instruments, such
as U.S. Treasuries, and to discontinue lending arrangements to
smaller businesses. Small and medium size thrifts could be
impacted by this flight to quality regardless of the strength
of the operations, resulting in liquidity, funding, and
operational problems for these institutions. This type of risk
is greatest among institutions that engage in secondary market
activities and are dependent upon private funding sources for
the continued sale of loans held for sale. Over the past 5
years, several thrifts and holding companies have experienced
disruptions in this regard.
In each case, the institutions were engaging in higher risk
lending such as auto, subprime, or high loan-to-value
mortgages. In each case, the thrift successfully managed the
difficulties. We consistently assess the liquidity risk and
contingency plans for thrifts and holding companies engaged in
this type of activity.
The other funding risk faced by thrifts is the higher cost
associated with borrowed funds and noncore deposits. Thrifts
with increased reliance on these funding sources must
consistently pay higher rates and are prone to rate spikes due
to increased competition or a rise in overall interest rates.
Thrifts can experience a compression in the interest margin,
and there is the risk that thrift management will shift to
higher risk activities to offset the decline in interest
spread.
Institutions that rely on borrowings sometimes opt to use
complex instruments that require sophisticated analysis to
evaluate the risk thoroughly. We have issued several bulletins
to the industry warning of the risk associated with these
complex instruments and setting standards for the evaluation of
the risks. In addition, we have recently enhanced our interest
rate risk model to account for impact of complex debt
instruments on a thrift's interest rate risk profile.
Q.2. While many analysts predict a recovery from the current
economic slowdown in the second half of the year, there is
still a chance that the downturn could be worse than expected.
If the economy were to perform below expectations, what
consequences would that have for the safety and the soundness
of the banking system?
A.2. Despite the recent weakness in economic activity, the
overall financial condition and performance of the thrift
industry is strong. The level of credit quality in the thrift
industry has remained high--in part due to the industry's
concentration in residential mortgage lending and its limited
exposure to commercial lending. In general, while the overall
quality of conventional residential mortgage loan portfolios
has remained high, the sharpest deterioration in credit quality
has occurred in the commercial, industrial, and nontraditional
mortgage sectors of the market. For instance, the chart below
shows the percentage of subprime mortgages, tracked by the
Mortgage Information Corporation that were in foreclosure over
the last 8 quarters. The data includes all grades of first lien
subprime mortgages. Since June 2000, the percentage of the 2.3
million subprime mortgages in foreclosure has increased by 47.3
percent, from 3.19 percent to 4.70 percent. Not shown in the
chart is a similar deterioration in the percentage of these
mortgages that are 30 days or more past due, which, as of March
2001, stood at 11.59 percent. The only positive news is that
although the June quarter illustrates further deterioration in
the subprime portfolio, the rate of increase in delinquencies
is not as large as it has been over the last 3 quarters.
The thrift industry's loan portfolio is heavily dependent
on the financial health of consumers since over 50 percent of
thrift assets are held in direct loans to individuals
residential mortgages (48 percent of assets) and consumer loans
(6 percent). We continue to monitor the economic factors that
impact the performance of consumer debt. The number of personal
bankruptcies continues to increase, and the debt burden
shouldered by consumers is near an all-time high. In response,
we closely monitor the risk-management practices of thrifts,
especially ones that have higher levels of unsecured consumer
lending or engage in high loan to value mortgage lending.
However, the impact of higher bankruptcies on most thrifts will
be muted due to the collateral coverage of real estate loans.
Although the level of subprime lending is not pervasive, it is
one of the fastest growing business segments in the banking and
thrift industries. We continue to closely monitor thrifts with
significant levels of subprime assets and note that some
institutions have begun to retrench their activities in this
area. While subprime lending can be profitable, some insured
institutions have entered this business line without the
appropriate risk-management practices, reserves, or capital
support, and a disproportionate number of problem situations
and failures have resulted.
The thrift industry's overall financial condition at this
point in the economic cycle is quite strong, and its level of
capital and reserves is more that adequate to absorb higher
levels of loans that might be expected should the economy
perform below expectations for some period.
Q.3. After 5 very good years, the rate of nonperforming
commercial, industrial, and personal loans increased by 26.6
percent in 2000. Can you please tell me what stress, if any,
this places on the banking system, and whether or not you
expect a similar rate of increase for this current year?
A.3. Troubled assets, which include seriously delinquent
(noncurrent) loans and repossessed assets, climbed to 0.62
percent of total savings and loan assets as of March 31, 2001,
from 0.60 percent at year-end 2000. Troubled assets reached a
record low of 0.58 percent of assets in the third quarter of
2000. As of the end of March 2001, noncurrent loan rates (loans
over 90 days past due or in nonaccrual status) increased to
0.53 percent of assets from the year-end 2000 level of 0.50
percent. Noncurrent consumer loans stood at 0.83 percent of
consumer loans as of March 31, 2001, up from 0.81 percent at
year-end. Noncurrent commercial loans jumped to 1.64 percent of
all commercial loans at the end of March from 1.52 percent at
the end of 2000.
While the recent increase in nonperforming consumer and
commercial loans has put downward pressure on earnings, the
current level of nonperforming loans in the thrift industry is
still relatively low. To date, nonperforming loans have not
placed an undue level of stress on the thrift industry. Indeed,
the earnings of the thrift industry have remained strong by
historical standards and the industry as a whole is adequately
reserved and well capitalized. Moreover, in contrast to
noncurrent loans, delinquent loans (those 30 to 89 days past
due) actually declined for most types of loans during of the
first quarter of 2001. While the recent decrease in delinquent
loans 30 to 89 days past due is encouraging, our ability to
foresee turning points in the credit cycle is limited, and
continued weakness in economic activity is likely to cause
credit quality to erode.
Q.4. Though the delinquency rates for credit cards and consumer
loans are well below the high levels experienced during the
last economic downturn, they have risen back to levels
comparable to 1993. What do you think the effects of this
increase in delinquency rates will be, with regard to both
consumers and the financial institutions that you regulate?
A.4. The increase in delinquency rates on consumer loans in
general and credit cards loans in particular is likely to
result in some tightening of credit standards, making it more
difficult and costly for marginal borrowers to obtain credit.
In addition, financial institutions are increasingly imposing
automatic increases in credit card lending rates when payments
are past due.
As noted above, noncurrent consumer loans stood at 0.83
percent of all consumer loans as of March 31, 2001, up 0.81
percent at the end of last year. The consumer loan noncurrent
rate is well below the recent peak of 1.32 percent reached in
1991. The recent increase in consumer loan delinquencies has
not had a significantly adverse effect on the thrift industry
in part because the noncurrent rate is still relatively low.
Moreover, only 6.3 percent of the industry's assets are in the
form of consumer loans. Nevertheless, the rise in delinquencies
is likely to prompt some thrift institutions to improve risk-
management practices, boost reserves, tighten lending standards
and increase lending rates and late fees.
The effect of higher delinquency rates on the availability
of credit is uncertain. We have seen a continued increase in
personal bankruptcies over recent periods; which has not been
accompanied by reduced credit availability. One factor that may
account for this effect is the use of improved tools for risk
adjusted loan pricing, such as credit scoring and automated
underwriting systems. Therefore, financial institutions have
continued to lend to consumers with various levels of credit
risk.
Q.5. According to a Mortgage Bankers Association survey, 10
percent of mortgages backed by the Federal Housing
Administration are now 30 or more days delinquent. An article
in the June 12 New York Times stated, ``The mortgage problems
underscore one main reason many policymakers and economists are
so concerned about whether the United States will enter a
recession this year.'' Can you please tell the Committee your
thoughts and concerns about the high level of mortgage
delinquency?
A.5. The vast majority of mortgages held by thrifts are non-FHA
insured, single-family mortgages. FHA mortgages are typically
made to low- and moderate-income families and many first-time
homebuyers. Although thrifts originate FHA mortgage loans, they
typically sell them to investors in the secondary market.
The delinquency rate on FHA mortgages is considerably
higher than the delinquency rate on non-FHA, single-family
mortgages. The delinquency rate on single-family mortgages held
by thrifts was only 1.67 percent as of March 31, 2001, slightly
above the 10 year low of 1.66 percent in 1999.
The difference in the performance of the FHA mortgages
relative to the mortgages held by insured depositories has
widened considerably. According to data from the Mortgage
Information Corporation, the difference in performance (as
measured by 30 days past due) was negligible in the early
1990's. As of the first quarter of 2001, FHA loans had a
delinquency rate 5 times higher than that of conventional
mortgages held by depository institutions.
The overall credit risk of the FHA mortgages has been
affected by increases in ARM lending, and by higher effective
loan-to-value lending programs. It has also been affected by
the ability of private sector lenders to offer more
creditworthy borrowers better terms than before, thus lowering
the credit quality of the pool of FHA borrowers, as those able
to get better terms elsewhere forego FHA loans. While the rise
in delinquencies of FHA mortgages is a matter of concern, the
thrift industry exposure to that sector of the mortgage market
is limited.
Q.6. I have heard from varying persons that the banking
industry has significant exposure in the telecommunications
sector. What is the direct and indirect exposure of banks to
the fallout in the telecommunications sector?
A.6. Fitch Investors Service reports that telecommunications
defaults for the first half of the year reached $15.5 billion
or 1.4 percent for the sector. Although many telecom companies
continue to struggle, there is minimal direct exposure to the
thrift industry. The troubled telecom companies will mainly
affect U.S. commercial banks. Mostly impacted by this fallout
are banks that have underwritten a company's bond offering or
the larger commercial banks that have private equity
investments in these companies.
Nevertheless, the thrift industry could experience some
indirect exposure through a rippling effect. If the financial
stability of these companies remains uncertain or worse, it may
adversely impact the surrounding area in which the business
operates. The most material indirect impact for thrifts would
be a decline in home values. However, most of the markets that
have a concentration of telecom companies also have relatively
diversified economies.
There is also some limited exposure if a telecommunication
company is providing services to a thrift. The inability of a
troubled telecommunication company to support the institution's
system may cause continuity of service problems and create a
reputation risk for the institution. Therefore, the quality of
a thrift's contingency plan is key to its success in overcoming
any failure. In addition to having a solid contingency plan,
management should fully understand each vendor's capabilities,
financial viability, and the extent of repercussions if
disruption of service occurs. Further, management must
understand the importance of utilizing a company with a sound
infrastructure. These steps should help mitigate any potential
failures within the telecom sector.
Q.7. According to the OCC, consumers are more highly leveraged
now than at any measured point in history. Not only are debt
service payments at historic highs, but the increase in debt
has been financed through instruments other than mortgages.
Credit card debt is rising very rapidly; the Chicago Sun-Times
reported that the average credit card debt per household is
$8,123 and has grown threefold over the past decade. Debt
service payments constitute over 14 percent of disposable
income. What do you believe the effects of this high level of
personal debt will be with regard to consumers, the banking
sector, and the economy as a whole? If the economic downturn is
worse than expected, what would be the effect of having so many
people so highly leveraged?
A.7. Consumer spending constitutes two thirds of our economy.
Consumer debt finances much of this spending. High levels of
consumer debt provides an immediate benefit to the consumer
(increased consumption), to the banking sector (as provider of
financial services), and promotes current economic growth. That
is not to say, though, that high levels of household debt are
not without costs and risks.
The cost of borrowing against future income to finance
current consumption (as opposed to investment) is that it will
eventually reduce future consumption. The risk of leverage is
that income might become insufficient to service the debt,
causing delinquencies and eventually, bankruptcies, creating
costs not only for the consumer, but also for the banking
sector and the economy as whole.
Three recent developments may affect consumers' ability to
service their high level of debt. The first is the Federal
Reserve's recent repeated cuts in interest rates. This will
tend to lower consumers' servicing costs, as, for example, when
they refinance their mortgages. The second is the recently
enacted tax cuts, which will leave consumers with more after-
tax income to service their debt. The third countervailing
development is the current economic slowdown, which will tend
to reduce income, thus making debt servicing more difficult for
many.
If the economic downturn is sharper and more prolonged than
expected, we would expect that payment delinquencies and
bankruptcies to rise, for the banking sector to face increasing
loan and revenue losses, and an economic recovery to take
longer, as consumer credit would become less available. For an
assessment of the specific impact on the thrift industry, see
our answers to question 2 and 4.
Q.8. Remittances are a large and growing economic reality that
affect millions of people both in America and south of the
border. It has recently come to my attention that this
industry, which recent estimates have put at more than $20
billion annually, often charges high fees and that many of the
leading companies have been challenged in court for having
hidden fees. In a New York Times article it is stated that
``the fees have run from about 10 percent to 25 percent or
more.'' Do you believe that there are problems in the manner in
which the bulk of remittances are made today? What steps has
your agency taken to analyze possible solutions including
fostering or creating alternative transfer mechanisms?
A.8. The cross-border transfer of money between Mexicans who
work in the United States and family members in Mexico is a
financial service that is largely provided outside the insured
depository banking system. These ``remittances'' represent an
activity valued by ethnic market segments that the traditional
banking sector has not fully recognized as a worthwhile
business opportunity. OTS has been active in encouraging
thrifts to understand the changing demographics of their
communities and to explore the needs of emerging markets. We
support institutions that develop creative products to respond
to underserved communities and that implement these business
initiatives responsibly and in a strategically and financially
sound manner.
Q.9. Former Treasury Secretary Summers has stated that ``all
high school students should receive a financial education,''
and that ``though personal financial education must begin in
the home, it must continue in the schools.'' Can you please
comment on the state of financial literacy and education among
Americans, including any deficiency in this area that should be
addressed? If you see any deficiencies, what do you believe can
and should be done with regard to these deficiencies in both a
broad sense and with regard to your agency? At the hearing, I
asked for information regarding any initiatives that your
agency has taken, including the Money Smart program. Could you
please provide this information in your submission to the
Record?
A.9. Anecdotal evidence suggests and is now confirmed by a
recent study by the Fannie Mae Foundation on financial literacy
education in the United States (see attached) that an
increasing number of public and private sector entities are
taking a more active role in helping to improve the ``financial
literacy'' of Americans. From our vantage point, we have
noticed a significant increase in the involvement of insured
depository institutions in financial literacy initiatives
through in school banking programs, homebuyer education
programs, and other financial education initiatives targeted at
youth, the elderly, lower income families, new immigrants,
Native Americas and others.
Many Americans lack basic skills in the management of their
personal finances. According to the JumpStart Coalition, many
young adults are unable to balance a checkbook and do not
understand financial principles involved with earning,
spending, saving and investment. Many young adults establish
poor financial management habits, and accumulate high consumer
debt. Moreover, the population of new immigrants in this
country is growing. This poses additional challenges given the
language and cultural barriers that often exist, as well as a
lack of understanding distrust of the banking system. The rise
in elder financial abuse, bankruptcies and predatory lending
problems is in part attributed to poor financial decisions and
the ability of others to prey on those who are financially
vulnerable or unsophisticated.
Deficiencies that we have observed with respect to
financial literacy programs are the lack of resources
(financial or human) to sustain programs or to expand their
reach to a broader audience. Moreover, there is not a good
system nationally for sharing best practices and program
curriculum--be they employer based, community based, or in
school programs.
Employer based educational programs and school based
programs are excellent ways to reach very large populations of
people. However, this type of training is generally not part of
the school curriculum nor is it offered is most workplace
settings. We would recommend urging more employers to offer
personal finance courses dealing with wealth creation, avoiding
financial problems or pitfalls, money management, savings and
investment strategies and retirement planning. Probably the
best time and place for people to learn the importance of money
management and wealth creation is in schools. In school banking
programs have had success in certain communities, as have
volunteer in school training programs such as Junior
Achievement and the JumpStart Coalition. Promoting and
supporting in school financial literacy programs is equally
important.
In underserved populations, community and faith-based
organizations play a major role in meeting the need of
individuals in these communities. These organizations are often
able to provide more than financial education. Support programs
aimed at life planning issues are often needed by many
individuals in addition to practical money skills. However, the
resources of these organizations are usually very limited and
must be used to address a variety of community development or
social service needs. Thus, these entities are well positioned
to reach a large segment of the market but are not well
equipped with the resources.
In addition to employer and school based programs, and
programs offered through community and faith-base
organizations,
financial education for older Americans should be a priority.
Financial management can help older adults avoid scams and
financial abuse, budget, plan, and manage daily money matters.
Education on alternative sources for healthcare, homecare,
estate planning and more complex financial products, such as
reverse equity products if they are homeowners, would benefit
older Americans.
OTS established a Community Service Program in 1998. OTS
employees participate as volunteer tutors in established,
legitimate financial education programs in local schools and in
the community as part of the agency's Community Service
Program. Examples of financial education programs that agency
staff has participated in over the past 3 years include Junior
Achievement, American Bankers Association's National Teach
Children to Save Day, Seahawks Academy Financial Literacy
Training, Central City Lutheran Mission Financial Literacy
Training, Operation Hope's Banking of the Future Day and the
Neighborhood Housing Services of New York Financial Life Skills
Course.
OTS participates in the Department of Treasury Partnership
in Education program, cosponsored with the National Academy
Foundation (NAF), by hiring summer interns from local high
schools. The National Academy Foundation is a nonprofit
educational organization that works to improve the quality of
education for students and access to career opportunities by
supporting partnerships between business and public schools.
OTS employees have also served as board members of the National
Academy Foundation Advisory Board.
OTS staff is also active with the Women in Housing &
Finance Foundation's Personal Finance Committee. The Personal
Finance Committee, co-chaired by an OTS staff member, provides
an opportunity for WHF members to offer volunteer-based
financial education to primarily low-income women and their
families in the Washington, DC area through partnerships with
local community organizations such as the Latin American Youth
Center, Ellen Wilson Community Development Corporation, Girl
Scouts, Jubilee Jobs, Cornerstone Group, For Love of Children,
Community Family Life Services, Hopkins House. Most recently,
we helped organize a financial education session on credit and
money management that was offered at the Women's Wealth
Building Symposium, a one day conference sponsored by Fannie
Mae and the McAuley Institute.
OTS has produced several financial literacy and consumer
education publications. Primarily through the Community
Liaison, a quarterly newsletter edited and produced by the
Community Affairs staff, OTS works to inform and educate the
industry about financial literacy issues and to highlight
programs that the industry is involved in. These consumer
education materials are available on OTS's web site,
www.ots.treas.gov, and include:
Individual Development Accounts (IDA's): Strategy for Asset
Accumulation, November 1998, Office of Thrift Supervision.
``Looking for the Best Mortgage,'' an interagency brochure with
tips on shopping for a mortgage, 1999.
``Working with America's Youth,'' Community Liaison, June 1999,
Volume No. 99-02. An article discussing financial literacy
programs in which some OTS regulated institutions are involved.
``How to Pickle a Coin of Fun Money in Cyberspace,'' Community
Liaison, June 2000, Volume No. 2000-01. Discussion of financial
literacy web sites for kids.
``Domestic Financial Abuse of the Elderly,'' Community Liaison,
September 2000, Volume No. 2000-02. Article about what banks
can do to combat elder financial abuse.
``The Path to Homeownership,'' Community Liaison, January 2000,
Volume No. 00-01. Article discusses several programs that
promote homeownership through vehicles such as IDA's and
homebuyer education.
``Washington Mutual Opens the Door to Affordable Homeownership
in Orlando,'' Community Liaison, November 1999, Volume No. 99-
03. This article highlights WAMU's homeownership center that is
used to educate consumers on the home buying process.
``Hope is Spreading,'' Community Liaison, June 2000, Volume No.
2000-01. This article profiles Operation Hope's financial
literacy program.
Q.10. Another disparity involved rules on loans to one
borrower. National banks are generally allowed to lend no more
than 15 percent of their capital on an unsecured basis to a
single borrower. Many States have higher limits for the banks
they charter. On June 8, 2001, the OCC announced a new pilot
program allowing national banks with the highest supervisory
rating to lend up to the State limit--but no more than 25
percent of capital to single borrowers under certain
circumstances. Please describe the competitive regulatory
disparity that led the OCC implement this pilot program.
A.10. This question can more appropriately be answered by the
OCC. Therefore, we defer to the OCC.
Q.11. In a speech before the American Bankers Association,
Federal Reserve Board of Governors Member Edward Gramlich said
that, ``Higher rates of national savings are among the unsung
heroes of the good U.S. economic performance in the late
1990's.'' However, the most recent data from the White House
shows a substantial decline in personal savings, from over 5
percent in 1996 to minus 0.9 percent today. Do you think that
this is a serious problem, and if so, what can we do to
ameliorate it? What position does this place Americans in if
the economic slowdown worsens? Finally, what are the effects of
this decline with respect to national investment levels and GDP
growth?
A.11. This answer can more appropriately be answered by the
Federal Reserve Board. Therefore, we defer to the Federal
Reserve Board.
Q.12. What steps has the Federal Reserve taken to promote
technology and innovation in the payments systems, and what
steps should it take? As well, are you concerned that the
initiation of payments on the Internet, or through another
electronic means, could affect the safe operation of payments
systems?
A.12. This answer can more appropriately be answered by the
Federal Reserve Board. Therefore, we defer to the Federal
Reserve Board.
Q.13.a. What forms, if any, of bank surveillance are done
through automated technology and/or the Internet?
A.13.a. OTS employs automated technology and the Internet to
conduct surveillance and monitoring activities. OTS developed
several automated systems to monitor the financial condition
and performance thrift institutions. These systems include the
Risk Assessment Model (RAM), the Thrift Monitoring System
(TMS), and the OTS Net Portfolio Value Model (NPV Model).
The RAM is used to identify thrifts exhibiting
characteristics that may lead to a CAMELS rating downgrade. RAM
uses a series of financial ratios to generate a ``RAM score,''
which ranks the likelihood of a ratings downgrade.
The TMS is used to identify particular areas of thrift's
operations that may warrant special attention and analyses. TMS
uses a series of financial ratios to measure adverse trends in
earnings, asset quality, liquidity, and capital. TMS also
incorporates Internet links to facilitate access to publicly
available information. TMS includes direct links to the home
websites of individual thrift institutions, as well as links to
sites with stock prices, credit ratings, Securities and
Exchange Commission filings, and news items. (All OTS analysts
and examiners have Internet access from their personal
computers in addition to that provided through TMS.)
The NPV Model is used to monitor the interest rate risk
exposure of individual savings associations. The NPV Model
employs scenario analysis to ``stress test'' the vulnerability
of thrifts to different interest rate enviromnents. In addition
to providing a means of identifying thrifts with high levels of
interest rate risk exposure, the NPV Model allows OTS to
distinguish between the speculative and nonspeculative use of
derivatives products.
OTS has an automated central filing system, the Electronic
Continuing Exam File (ECEF), which provides OTS staff with
access to essential information on individual thrift
institutions. The ECEF contains financial data, correspondence,
examination reports, enforcement actions, news items,
monitoring comments and other relevant information. The ECEF
facilitates examination planning and reduces time gathering
information prior to an onsite examination.
Q.13.b. Does your agency have plans to augment the role of
automated technology in gathering and disseminating
information?
A.13.b. Yes, we are continually exploring ways to take
advantage of new technology to further the mission of OTS, to
improve our efficiency and effectiveness, and to minimize the
burden on the institutions we regulate.
Since 1993, OTS has provided the thrift industry with
electronic filing software to facilitate data entry, editing,
and transmission of regulatory financial reports. The software
includes validation edits, so the thrifts can check reports for
errors prior to transmission to OTS. The software saves
considerable time for both OTS and the industry and helps to
ensure greater data accuracy. We have enhanced the software to
provide the industry with the capability of communicating
electronically with OTS, a significant improvement in
expediting the data edit/validation process. We are currently
exploring the use of web-based technology to achieve greater
efficiencies in data collection and dissemination.
We have approved an initiative to stand up an Extranet to
facilitate the secure exchange of information with the
institutions we regulate and other regulatory agencies. Thrifts
would use the Extranet to file financial data with OTS, to
retrieve information for their institution (that is, interest
rate risk reports, performance data, examination reports), and
to submit corporate applications (that is branch office, change
of address) electronically to OTS. The Extranet would also
serve as the secure, electronic distribution point for data we
currently share with the other financial regulatory agencies
via tapes, CDs, etc.
We are continually adding to the information available
through our public website to enhance the flow of information
to thrift institutions and other interested parties. Current
OTS web content includes: press releases, proposed regulations,
comments on proposed regulations, OTS contacts, institution
directory, applications received, CRA public evaluations, OTS
handbooks, Thrift Financial Report forms and instructions,
technical bulletins, and more.