Tough Love That Saved Banks Could Cut U.S. Deficit

Thanks to a firm government policy that could give direction on the budget deficit and hope for California, banks across the nation have recovered and loans to business are fitfully growing again after more than 3 1/2 years of decline.

Unfortunately, the recovery doesn’t yet include California, where 70% of the banks are restricted by regulators from making new loans to business, and the recession is so bad that only 5% of the borrowers coming to the banks qualify for a loan anyway.

Yet there are grounds for hope that the same rigorous policies that worked nationally will give California a strong banking system ready to help business when the economy turns.

What is certain is that the nation’s banks will not go the way of its savings and loans. The number of problem banks listed by the Federal Deposit Insurance Corp. is now 671, down from 1,394 at the end of 1988 when there were such worries about a collapse of the U.S. financial system that the government took strong action to discourage lending.

That action dealt a body blow to an already weakening economy, but it started the process of reform that has changed U.S. banking from a largely slow-witted business to a competitive, healthy industry able to provide a foundation for a stronger U.S. economy in the next few years.

And thereby hangs a tale with significance for our central problem of the government budget deficit. To understand why, you can forget the current debate over President Clinton’s budget plan, and all the wonders and terrors predicted for it--that the plan will make jobs and lower interest rates, or that taxes will throw the country back into recession. Neither claim is credible. The economic facts are that present cuts in defense spending, along with California’s recession and those in Europe and Japan, are responsible for the snail’s pace U.S. recovery.

But the budget debate ultimately is about politics, not economics. The question being considered is not whether the economy will grow, but do Americans and their elected representatives have the discipline to curb deficit spending on entitlements--whether Medicare, welfare or subsidies for crops, jobs and industries?

In the case of the banks, the country has shown discipline.

In 1989, Federal Reserve Chairman Alan Greenspan was alarmed that bank reserves held against loan losses were at their lowest point since the Civil War, even though risks had grown. He urged the banks to raise capital, which meant they had to shrink--make fewer loans, take on fewer deposits. And so they did. Business loans since then have declined more than $60 billion--at least $11 billion in California alone. Other loans were also cut back. Small business was hit hard, and economy went into recession from which it has had a tough time coming out.

The policy had teeth. Regulators forced banks to close out loans and shut off borrowers who might have been carried in other times.

Banks were closed or merged--strong companies like Boatmen’s Bancshares, Banc One and Nationsbank expanded by acquisition. In California, BankAmerica took over Security Pacific. Nationally, the number of banks has gone from 12,713 in 1989 to 11,328 today; in California from 441 to 404.

There was a positive side. As interest rates fell with reduced lending and recession, banks began to make healthy profits on government securities--they could take deposits or borrow from the Federal Reserve at 3% and invest in Treasury securities at 7%, booking a safe and handsome profit.

“They also became efficient,” says James McDermott, research chief at Keefe, Bruyette & Woods, an investment firm specializing in bank stocks. “They cut costs and found new ways to cater to customers, earning fees for cash management and other services.”

It didn’t take long for Wall Street to notice. Since 1991, bank stocks as a group have outperformed the market. And some analysts now say that bank stocks--powered by 10%-earnings growth on average--could be the engine that leads the stock market in the next few years.

Those analysts are talking typically of banks like Norwest of Minneapolis and Integra Financial of Pittsburgh, not of banks in California.

But the same renewal can happen here, says Jim Davis, who was brought in as president to run El Segundo Bank. New approaches are being made. Last Wednesday, for example, the Controller of the Currency’s field officers--the chief federal bank regulators--held a meeting in Los Angeles with the presidents of 50 Southern California banks. The regulators said they would try to be more flexible about forcing banks to shut off small business borrowers, but they added that they couldn’t change the law or federal policy.

“I felt it was a reassuring meeting,” says Davis. “The message was we’re all here to help business.” Robert Turicchi, president of Harbor Bank in Long Beach, agrees. “All we need is for the economy to turn, and we’re ready to lend,” he says.

That’s a significant point. Banks don’t lead an economy out of recession, but when loan demand from business picks up, it’s essential the banks be ready to meet it. That’s why it’s so important that the U.S. banking system has recovered.

“With banks healthy and lending, economic growth could get quite strong in 1994 and ‘95, whether the budget proposals are adopted or not,” says Albert M. Wojnilower, senior economist of First Boston Investment Group.

The lessons of bank policy for budget reform are clear. First, it was unflinching. When S&Ls; got in trouble in the early ‘80s, Congress, reluctant to shrink the industry, loosened the reins. The result was disaster. So in 1989, with bank failure threatening, the policy was to tighten up--force the industry to get efficient.

Just so. The same kind of firm decisions on entitlements will rein in the budget deficit. Sure, how the pain is to be spread around is a political question. But as the banks have shown, political discipline can yield economic rewards.