Bank Failures Show Need for Tougher Rules
Last week’s pair of announcements involving mergers of major Texas banks was a jolting reminder of the sad health of the nation’s banking system. Financial institutions keep disappearing largely as a result of having made too many risky loans. This has forced many to close and propelled others into marriage with stronger partners. In Texas, much of the problem reflects too many loans made to drill for oil at a time of unbridled optimism about rising prices.
The problems in Texas and elsewhere continue to mount in large part because there’s an oversupply of lenders across the country. To compete in this environment, the most troubled of the institutions seek to get healthy by accommodating high-risk borrowers and charging them high interest rates. In the process, many of these lenders simply dig themselves a deeper hole.
Weak institutions--some small, some very large--are able to continue this activity because federal deposit insurance makes it safe for depositors to give them their money. The result, observes Lowell L. Bryan in a perceptive article to appear in the Harvard Business Review next month, “is an unhealthy concentration of credit risk in our weakest institutions that creates instability and puts stress on the entire system.”
Bryan, a former commercial banker who is now a senior partner in the consulting firm of McKinsey & Co., argued in an interview that the system “is really broken and getting worse.”
Picture Is Chilling
Statistically, the picture is chilling. In 1968, commercial banks charged off $300 million in bad loans. Last year, they charged off $13 billion, and this year’s total will be higher. These numbers, Bryan points out, amount to 60% of banks’ reserves and between 60% and 70% of bank earnings.
“Should we have a significant recession, our experience is that these chargeoffs will triple,” Bryan says.
He blames some of the problem on lenders, particularly savings and loans, being too cozy with government regulators. “The chumminess has resulted in a regulatory void that has allowed a large number of thrifts to lend federally insured deposits incompetently,” he writes.
What is the way out of this mess?
For one thing, some of this oversupply of lenders must be removed from the system. Bryan expects “literally thousands” of organizations to disappear.
For another, new regulations are needed to limit the lending risks that can be taken with those federally insured deposits. Various proposals have been put forward in this area, including charging banks and savings and loans more for insurance as their bad-loan experience worsens.
Beyond that, the growing practice of converting loans by banks, thrifts and others into securities that can be sold and traded like common stock could help if properly controlled. This would redirect the activities of the industry to serving as loan originators but not as big holders of loans.
Lacks Regulation
The problem, however, is that this “securitization,” as the industry calls it, is not adequately regulated, raising the prospect that some of the risk currently being taken by lenders would be transferred to other investors buying the securities.
A tremendous volume of such securities already has been sold. About $600 billion of securities backed by pools of mortgages will have been marketed by the end of 1986. Car loans and even credit card borrowing now are being securitized. Nearly $10 billion in securitized auto loans are now outstanding, according to the Review article.
“We’ve got a system that’s gotten ahead of the rules,” Bryan maintains.
Considering the number of banking disasters recently, it is clear that tougher regulation and auditing of lending practices is a must. Because so many new institutions have failed, more scrutiny of applications to create these start-ups is badly needed. At the same time, there should be a broad look at how to ensure that securitization reduces risky lending and doesn’t just shift risks elsewhere.
