WHEN business conditions are depressed, overly zealous bank regulation can strangle an already deflated economy.
At the same time, the last thing we need is a repeat of the past decade -- when banks speculated and regulators allowed banks to throw good money after bad, before belatedly shutting more than 1,000 of them
Stung by the excesses of the 1980's of the 1980s,Congress recently passed legislation imposing mechanical formulas on bank lending and requiring the banks with weak portfolios to increase their capital.
In this recession, there is now a serious danger that banking policy will overcompensate for the mistakes of the booming 1980s.
But how can bank regulators discourage unsound practices, yet not be so rigid that they starve the economy for credit? Interviews with several senior bankers, bank regulators and banking experts suggest that this balancing act is difficult -- but not impossible.
In a recession, the regulators need to lighten up in three distinct areas: the treatment of failed banks and their customers, the treatment of bank borrowers whose collateral has lost value in a depressed economy and the treatment of banks with inadequate capital.
* Failed Banks
In normal times, when bank failures are rare, the Federal Deposit Insurance Corp.'s practice of dividing the assets of a failed bank into "good" and "bad" loans makes sense. Typically, another bank takes over the performing loans, and the bad loans are liquidated -- but a whole regional economy doesn't suffer. But in regions such as New England today or Texas and the farm belt in the mid-1980s, this policy has proved to be self-defeating.
It is penny-wise, pound-foolish for the FDIC to focus on its own balance sheet above all else, emphasizing debt collection at so many cents on the dollar, dumping properties onto a depressed market -- when the effect is to deepen regional recessions. The FDIC should function at times like a the Depression-era Reconstruction Finance Corporation, pumping in capital, working with banks and borrowers rather than closing them down. If this is beyond the present mission of the FDIC, then perhaps we need a new RFC.
* Non-Performing Loans
In a recession, when the market value of collateral falls, many loans suddenly fall into a contradictory category that bankers call "performing non-performing loans." The loan is technically "non-performing" because the collateral is less than the amount of the loan -- yet the borrower is making the payments on time.
In a conventional bank examination, all of these loans are counted against the bank, which must put up capital reserves against the risk of loss. That depletes the bank's own capital and its earnings, which depresses its ability to make loans or raise other capital. Astonishingly, the Fed and the FDIC don't even keep track of what fraction of "non-performing" loans are actually current on payment of interest and principal.
This also suggests why reliance on rigid formulas as a test of bank soundness can be bad policy. In a recession, the exact value of loan collateral, the exact fraction of non-performing loans in a bank's portfolio, and the exact ratio of capital to assets cannot be calculated, and are less important than the regulator's judgment about more subjective questions: Does bank management know what it is doing? Did the bank take unnecessary speculative risks when times were good? Is the bank in trouble because of economic conditions beyond its immediate control?
A conventional bank examination doesn't pose these questions, but in a recession they are crucial in determining whom to shut down and whom to prop up. Mechanical formulas are no substitute for discerning supervision.
* Bank Capital
The regulators are on a crusade to get banks to "rebuild capital." But it's almost impossible to do that in a recession. By all means, banks should be better capitalized. But where a bank is otherwise sound, that process needs to occur gradually, over the course of the business cycle. To demand that a bank attain a specified ratio of capital to loans all at once is to compel it to reduce its loans.
There are some hopeful signs that the regulators are beginning to seek a necessary middle ground -- between 1980s-style go-go banking, and the dead-stop banking of the 1990s. In spite of itself, the FDIC is beginning to operate a bit more like an RFC and less like a liquidator. For example, the FDIC has started working with the Small Business Administration to keep credit flowing to businesses in regions littered with bank failures.
Bank examiners were justifiably traumatized by the bank failures of the 1980s. In December, the FDIC, the Fed, and the comptroller of the currency instructed their examiners to stop shooting the wounded, though examiners who lived through the 1980s will probably be shell-shocked for the rest of their careers.
Despite their shared guilt for the banking disaster of the 1980s, Congress and the bank regulators both need to resist the temptation to prove their toughness by fighting the wrong war.
A bust requires different reforms than a boom.
Robert Kuttner writes on economic matters. This is the second part of a series on the banking crisis.