Choking the Economy by Overregulation : Lending: Banks are hesitant to make small-business loans in the face of onerous federal rules.

Because bank credit has historically been the essential element for economic recovery, President Clinton’s first step in lifting our staggering economy must be to break lending gridlocks.

It’s not that bankers aren’t willing to make loans. Lending is their primary source of income and they need no cajoling to continue doing so. On the contrary, as the President learned during his economic summit, the primary obstacle in the way of new lending is a misguided regulatory policy that does more harm than good.

While no one disputes the need for prudent restrictions on bank safety and soundness, excessive protections come at a great cost. According to a study just released by the Federal Financial Institution Examination Council, the nation’s banks may have spent up to $17.6 billion in 1991--some 97% of their profits--jumping through hoops of federal regulations.

It cannot be overemphasized: needlessly burdensome regulation has a tremendously adverse impact on our economy. The cost of regulatory compliance reduces a bank’s capital by consuming profits and lowering retained earnings. Since every $1 in capital may support an additional $8 to $12 in credit extended, anything that reduces capital has a similar multiplier effect on reducing total extensions of credit.

Consider the direct impact on bank lending and economic growth of the compliance costs as estimated by the examination council. If only 25% of the $17.6 billion in compliance costs could be redirected to capital, it would support additional lending of between $35 billion and $50 billion.

As alarming as those numbers are, compliance costs are expected to further soar in the coming years as the result of last year’s passage of the Federal Deposit Insurance Corp. Improvement Act, which added more than 150 new regulations and rules. Most significant, the improvement act greatly encourages banks to avoid taking any new lending risks with federally insured deposits. However, since the essence of banking is taking prudent risks, the absolute aversion to risk that is now expected of banking has rather ominous implications for our prospects for an eventual end to the “credit crunch.”

The banking industry’s currently skittish attitude toward lending is largely due to the fear of being second-guessed by regulators. Congressional pressure has forced bank examiners to take a much harsher view of portfolios, requiring banks to back their loans with more reserves, which reduces bank earnings. Regulators have even been aggressive in forcing write-downs of loans that are only potential problems. They are being classified as substandard even though borrowers are still making timely payments.

Consequently, banks are now hesitant to provide extensions of credit where an immediate forced write-down is possible, regardless of how they believe the loan will perform. Furthermore, because of the increased scrutiny of small-business loans by bank examiners, such loans require as much paperwork as do loans to Fortune 500 companies, making them far less profitable and desirable to make.

As a result, bank lending to small businesses has plummeted. For the first time in 27 years, banks are investing more of their depositors’ money in Treasury securities than in business lending. This bodes poorly for the prospects of a strong recovery, since small businesses historically have been the source of growth and jobs. In California, 85% of new jobs are reported to be generated by small businesses. It appears that under the Improvement Act, lending to small businesses will remain difficult at best.

If credit is to flow again, California lawmakers, community leaders and business representatives must recognize the structural barriers to the extension of commercial credit and insist that Congress revise the improvement act and other unnecessarily burdensome regulations.

It is certainly not suggested that banks forgo regulatory supervision, since many of the industry’s regulations are appropriate and provide public benefit. The time has passed, however, when these regulations can be thought of as cost-free, which has long been the attitude of Congress.