Banks in crisis

Robert Kuttner

January 20, 1992|By Robert Kuttner

THE FEDERAL Reserve has cut the interest rate to its lowest level since the mid-1970s. But bank examiners, who were asleep at the switch during the speculative orgy of the 1980s, are now overcompensating with a belated and ill-timed determination to fly by the book. This has happened before.

The year was 1937. After sputtering toward prosperity, the economy had sunk back into depression. Marriner Eccles,President Roosevelt's Federal Reserve chairman, was trying to make bank credit plentiful, in the hope that easier money would ignite a recovery.

But the bank examiners at the Treasury's Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation were undercutting Eccles' efforts -- by the way they rated bank loans.

In a depression, property values fall. That means the value of bank collateral falls. In a depressed market, if bank examiners use the current market value of property or a business to determine if a loan is backed by sufficient collateral, the loan is likely to be rated as a bad loan.

That in turn means the bank has to set aside its own capital to cover the bad loan -- which then causes the bank to shrink its entire lending activity.

"If the [Federal Reserve] System is committed to a policy of monetary ease in times of depression," Eccles wrote in his memoirs, "then bank examination policies should follow a similar commitment."

In April 1937, Eccles sent Roosevelt a memo urging that monetary policy and bank supervision be consolidated in one agency. But Roosevelt was under fire for attempting to pack the Supreme Court, and he didn't want to be accused of yet another power grab. Eccles never got his wish: Bank supervision continues to be split among the Federal Reserve, the Comptroller, the FDIC, and 50 state banking agencies.

Fast forward 55 years. The FDIC, hemorrhaging money to pay the costs of past bank failures, is today behaving more like a liquidation agency than an agency of economic recovery. When a bank fails, the FDIC must repay insured depositors. To minimize its loss, the FDIC typically divides the bank's outstanding loans into good loans and bad loans, based on the market value of the collateral and on whether the borrower is current in his payments.

The failed bank is usually merged into a healthy bank, which takes over the "good" loans. The "bad" loans are then seen as candidates for liquidation. The FDIC attempts to collect whatever it can on those loans, either through its own liquidation branch or through a contract with a private collection agency which gets a commission based on what it collects.

The trouble with this liquidation mentality is that some of the "bad" loans -- many billions worth -- are actually current in their payments. They represent viable businesses stuck with collateral whose value is depressed in today's recession market. Yet by operating this way, the FDIC only starves the economy for credit, and worsens the recession.

William Taylor, the new chairman of the FDIC, is said to be sensitive to this dilemma. Taylor has told associates that he doesn't want the FDIC to function as merely a liquidation agency in a depressed economy. For example, in New Hampshire, where seven major banks failed, the FDIC is pursuing the alternative course of keeping banks open and providing additional capital, rather than just liquidating.

However, Taylor is constrained by the FDIC's mission, which is to be a deposit insurance corporation, and not a reconstruction finance corporation. He is also constrained by congressional determination to limit taxpayer exposure, and by the chastened mentality of his own examiners in the field.

As Marriner Eccles warned, "A radical scaling down of debts would clearly prolong the depression . . . it would require the further liquidation of banks . . . it would freeze credit and make for endless deflation."

But is there any way to make bank examination sensitive to recession conditions, without throwing away the rule book and inviting repetition of the abuses that led to the losses of the 1980s?

I believe there is, and this will be the subject of my next column.

Robert Kuttner writes a regular column on economic issues.


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