The author has chosen to use a question-answer format in order to make the often complex subject matter, easier

and more enjoyable to read. Q and A is not a dialogue between real people -- the author has provided the dialogue for both Q, standing for Quaero, which is Latin means "I search for" and A, Auctor, which in Latin means "person responsible."

Taking a Stand on Banking

Q: You realize of course that many people blame the costly savings and loan bailouts and the increased number of bank failures on deregulation. There are currently calls for stricter controls and higher capital reserves. What's your stand on this issue? A: My initial approach is the same in dealing with any public policy issue. Human nature must be taken into account. First, people are going to do what they want to do . They will find a way around the best laid government obstacles. Second, people act in their own self-interest and know better than an impersonal government where those interest lie and how to attain them. Third, a free market, based on the first two premises, functions more efficiently than a bureaucracy. Q: I think you have just advocated "more of the same"---laissez faire---what might be viewed by some as a prescription for disaster. The current weakness in the economy has been traced to the weakness in the banking system. A: And the weakness in the banking system may be traced to regulations which distort the market and wreak economic havoc. Q: I think the real question is whether regulators can protect taxpayers and promote economic growth at the same time. Are they mutually exclusive goals? Will easy credit hurt the banking industry? A: According to congressman Charles Schumer of New York, the banking system is shell-shocked from too much lending, too many new ventures undertaken in the eighties. Now bankers are cautious and investing in U.S. treasuries for safety. Unfortunately government securities are non-productive liquid type investments that will not provide the shot in the arm that the economy needs at the end of 1991. Q: Why don't we start our discussion at the beginning with the earliest link between government and banking in this country? Didn't we have a central bank early in our history? A: You're right. In 1791 Congress created the first Bank of the United States.
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Q: What happened? A: There was the time-honored heated debate involving states rights versus federal rights and as a result when the charter came up for renewal at the end of twenty years it was allowed to elapse. Congress tried again, forming the second Bank of the United States in 1816. Q: And obviously that didn't last. A: It was virtually destroyed with the election of its foe, Andrew Jackson, in 1832. The bank had become extremely wealthy and Jackson feared the power its officers could wield in influencing the government. He order his Secretary of the Treasury to withdraw all government funds and instead deposited the government's money in various state banks, referred to as "pet banks". When the charter of the second Bank of the United States expired in 1836 it simply ceased to exist. Q: So when did today's federally chartered banks come into existence? A: Congress passed the National Bank Act in 1863 to help finance the Civil War. This was the beginning of our dual banking system with some banks chartered and protected and regulated by the federal government and others by the state. Q: You know, the Japanese established the Ministry of Finance, their version of our Federal Reserve system, in 1882. A: That was long before we established our own Federal Reserve System in 1913. Actually the modern structure of our banking system began in 1927 with the passage of the McFadden Act. Q: I've never heard of the McFadden Act. A: It denied nationally chartered banks the right to operate branches within a state unless the already existing state chartered banks were given equal rights. The McFadden Act originally permitted national banks to exercise securities powers. It wasn't until 1933 with the passage of the Glass-Steagall Act that banks and savings and loans were forbidden to underwrite securities. Q: This was New Deal legislation instituted under Franklin Roosevelt. Right? A: Right. It was an attempt to insulate the various types of banks from competition by commercial enterprises and also to protect consumers from having their deposits used by banks speculating in the stock market. Q: I guess the crash of 1929 was a fresh and scary memory in 1933.

A: Absolutely. 5,500 banks failed in the 1920s. In just the three years 1926-1929, 125 banks failed in Florida alone, as a result of insider abuses and conscious conspiracies to defraud. The officers of the Palm Beach National Bank should have been indicted in the summer of 1926 for embezzlement and criminal fraud, according to the bank's receiver, but instead an official political statement was issued claiming the bank failed because of the local economy and unforeseen disasters which hit agriculture and industry in South Florida. Q: A cover up! A: The officers of a defunct state bank were indicted for making illegal loans by a grand jury in Palm Beach County a few months later. Q: I bet that was small comfort to depositors who lost their savings. A: Now it is taxpayers rather than depositors who pay for the excesses and abuses of management. Q: You mean because ultimately taxpayers stand behind the government-guaranteed deposits? A: Exactly. Let me backtrack to 1913 to the establishment of the Federal Reserve Bank which was supposed to ensure the soundness of the banking system. Q: The number of bank closures during the Great Depression bears testimony to the fact that it didn't do its job. A: You should know by now that when one agency fails to do its job, the usual government solution is to add another agency and so we got the Federal Depository Insurance Corporation (FDIC) and the Federal Savings and Loan Insurance Corporation (FSLIC). But just like any safety-net, deposit insurance, introduced in the 1933 Glass-Steagall Act, has encouraged risk and poor management. It has distorted the system. Q: What do you mean? A: Originally the Federal Depository Insurance Corporation (FDIC) was supposed to stop runs on banks, but instead it has effectively stopped depositors from keeping an eye on their savings, and bankers from being prudent. Q: Best selling author and former banker Paul Erdman, on March 5, 1987, told his Commonwealth Club audience that

Every money center bank in the U.S. gets over half its deposits from abroad...the consensus of the Wall Street types is that it (i.e. run on U.S. banks) has a 25 percent chance of occurring. But no big deal, he said, even if runs occur--the world's money has no better place to go! A: FDIC insurance now covers any deposit up to $100,000. As long as a deposit remains under that $100,000 level it is the responsibility of Uncle Sam to monitor bank judgment. Q: How many people do you know with $100,000 sitting in the bank? A: You've got a point. But it's worse than you think. Currently an individual or group can be insured beyond the $100,000 limit just by opening another account once the $100,000 insurance limit is reached in one bank. A recent reform limited the number of insured accounts to two in any one bank. Q: Some reform! The customer could go across the street to open up accounts three and four! A: Well I know if the Bush administration were to have its way, large pension fund deposits would no longer be insured on the pass-through theory. Q: What in the world is the pass-through theory? A: The theory that says that entities like pension funds, should be considered as so many individual deposits, each below the $100,000 ceiling deposits. The fact that they are lumped together should be overlooked for insurance purposes. Q: Maybe it's time something was done towards gearing bank premiums to risk and perhaps even trimming the guarantee from $100,000 to a modest sum more in keeping with the average mans savings, since he is the one who gets tapped if a bailout is needed. And how about prohibiting one person from having several insured accounts totaling over $100,000? A: Why not? Pay outs could be lessened by reducing the dollar amount of deposits covered below $100,000 and limiting the pay outs to a per person liability rather than per account. That was supposed to have been done in 1984 when the FDIC and the Federal Home Loan Bank Board supposedly banned new brokered accounts. Q: Brokered accounts? Is that what they call the really large deposits which are split into $100,000 accounts split to take advantage of FDIC insurance limited to that amount? A: You've got it! Another idea is to balance the FDIC's income-outgo ratio by co-insurance.

Q: You mean requiring the depositor to pick up at least some of the tab for insuring his own particular account? A: Absolutely. In fact why not do away with the FDIC and go back to caveat emptor. Q: In other words, why not let individual depositors shop for their own deposit insurance? A: Opponents claim banks would be open to runs, something deposit insurance was supposed to alleviate. Besides, private insurers couldn't begin to assume a $4 trillion liability. Q: Then why not categorize banks? There could be "safe banks" where deposits are invested in government and agency securities, and home mortgages. These banks could be covered by the FDIC---backed ultimately by taxpayers. "Risky banks" would have more investment latitude but depositors would not be provided with insurance. Of course they could obtain their own. A: Dream on! Insurance for depositors of a risky bank would be sky high. But I see two other problems: First, most consumers would prefer the risky banks because of the higher possible returns. Americans are optimists! According to Lowell Bryan, author of Bankrupt: Restoring the Health and Profitability Of Our Banking System, most institutional investment, a total of one billion in deposits and other borrowed funds, would leave the insured safe banks. Secondly, the investments that make safe banks safe, like Treasury bills and so forth, are already backed by taxpayer guaranties, making FDIC protection redundant. Q: From what I read, Lowell Bryan would favor categorizing the banking business. He even refers to core banks, federally insured and in the business of taking deposits and lending to small enterprises. He envisions only ten to twenty of these banks formed via mergers of what are now the 120 largest bank holding companies who have two-thirds of the country's deposits. My facts differ from yours. In a review of Mr. Bryan's book [Business Week 8-5-9]) it was said that: Of the $2.6 trillion now in bank deposits, Bryan calculates, about $600 billion might leave core banks for higher yields offered elsewhere. More risky business would go to money-market investment banks and finance companies which would primarily make loans to real estate investors. A: What can I say? Co-insurance is something to play with though.

Q: I like the idea of co-insurance too. There are almost unlimited possibilities for funding insurance by combining, in one way or another, resources of the government, the banking industry and of individual depositors. Q: Where does FDIC get its money now? A: Banks pay premiums into the Bankers' Insurance Fund (BIF). These premiums exceeded disbursements leaving as much as $18.3 billion in the fund as recently as 1987. But by the end of 1991 the insurance fund had dropped pretty near to zero because of the increased number of pay outs. Q: You mean pay-out caught up to premiums? A: Exceeded premiums, because of the large number of bank failures. Q: So you're saying by 1992 the insurance fund will be insolvent? A: Not so much insolvent, as illiquid. Q: What's the difference? A: Insolvency is a permanent inability to meet obligations whereas illiquidity signifies a temporary but rectifiable shortfall. The BIF, which is part of the FDIC and because more people are familiar with the FDIC I will simply use that term for ease of discussion, still has a source of income and good long-term prospects of solvency. It's just that its income is spread out over a long time period and the need for disbursement is concentrated and immediate because of the unprecedented bank failures. Q: So what's the solution? A: Adding capital to a reformed system. A: Yes, adding capital to a reformed system. Q: Oh, is that all? A: Let's take it a step at a time. As we said, we can give the FDIC an infusion of capital by borrowing, either from the banking industry, the Federal Reserve Board (Fed) or taxpayers. Which will it be? Q: I have a sneaky feeling that this is one of those questions where no matter the answer; it's going to come down on the taxpayers. A: Let's eliminate the Fed as a potential saviour because of the precedent any bailout of the banking industry by that independent agency would set. There are plenty of other agencies that would soon press the Fed to advance funds to them.

Q: But I thought the Fed was expressly set up to insure the stability of the nation's financial and banking system. Having the Fed ride to the rescue seems to be a legitimate and practical solution. A: You're right that the Fed can, should, and has inserted funds into the system in emergency situations to insure stability, but we're talking here about long term recapitalization of an insurance fund. Let's examine the other alternatives. Congress has recently [fall of 1991] been working out the fine points on legislation that would have the Treasury loan seventy billion to recapitalize the FDIC. Q: The U.S. Treasury? Just as I thought; that's in reality a taxpayer bailout just like the Savings and loan bailout. A: Not "just like". Q: Oh sure, the banks will pay back the loan out of premiumsmaybe even larger premiums due to higher assessments, but remember the savings and loans were supposed to pay back taxpayers (the Treasury) out of the sale of foreclosed assets. A: That's different. Those assets were mostly real estate. Due to changes in the tax code and the economy, real estate values have fallen and the cost to foreclose and manage them has gone through the roof. Q: Not to mention the regulations and restrictions which have hamstrung the liquidation process. A: There's no doubt that the delays have been extremely expensive. But you must admit that the source of loan repayment by the banks is more easily identified than the source of the S & L loan repayment. Q: You mean the banking industry reimburses the Treasury via premiums charged to member banks whereas thrifts are forced to depend on the proceeds from asset sales--mainly real estate. A: Exactly right. Premiums receivable can be calculated, whereas the net income from property sales is inscrutable. Q: But what is not known is the cost of an undetermined number of bank failures. That cost will ultimately determine the net premiums available to service any Treasury loan to the FDIC. A: That's why the solution is more than recapitalization. Reforms are needed to reduce the number of bank failures. Q: Reforms such as?

A: That is the debate that is going on. Some experts favor measures to restrict the range of bank activities, linking deposit insurance premiums with individual bank risk, raising the capital requirements of banks and more frequent examinations of bank records and management. Q: I suppose which activities and the degree of restriction would be left to fallible legislators and regulators, many with little expertise in financial fields. This does not sound like something you would favor. A: You're right. Aside from my philosophical abhorrence, I see giant pitfalls and would prefer that the marketplace determine the kind and degree of restrictions. If regulators are too restrictive they could cause, rather than prevent, bank failures. Q: Don't forget the cost entailed in requiring more frequent examinations and higher capital reserves. A: Bank managers will have greater incentive to act prudently once they have more capital on the line and this, by itself, should reduce the probability of bank failures. Q: What about tapping the reserves of the banking industry? A: That's on the agenda. For instance, I can't figure out why foreign deposits are bypassed when calculating the premiums banks must pay into the Bank Insurance Fund. Q: You mean foreign deposits aren't insured now? A: They're insured if the bank fails but they are not counted when determining the size of a bank's premium. They get a free ride. Q: I would think that would make foreign funds a preferred source of capital for banks! A: You're right. This is a regulatory induced bias. Q: I've got another idea. In his 1991 book, The S&L Debacle, Professor Lawrence White suggested, All banks would be required to buy amounts of "preferred stock" in the FDIC equal to one percent of their domestic deposits, and they could carry this stock at par on their balance sheets. This way the FDIC would get an infusion of approximately $25 billion and banks would receive dividends on their investments. Since they could carry the preferred stock on their balance sheets as an asset, the banks net worth for accounting purposes---assets minus liabilities--would not go down.

A: Excuse me. Wouldn't that amount to double-counting? I can't see letting the FDIC include the twenty-five billion banking contribution in its resources while also allowing the banks to carry the par value of the twenty-five billion preferred stock on its books. Q: OK. How about if the preferred stock is publicly held and traded just between banks, and the preferred stock is carried on bank balance sheets at current market values as reflected by that trading? A: I don't think it is possible to strengthen the FDIC via banks funds, without weakening the banks. Q: If I'm right, banks place their capital reserves with the Federal Reserve Bank which gets away without paying any interest on those reserves. Why not make the Fed pay interest? A: Sounds good on the surface, but remember the Fed pays any excess funds into the Treasury, so any interest paid by it would ultimately reduce the Treasury's income and just be one more hit on the taxpayer. Another suggestion is to lower the legal lending limit of federally insured institutions. Q: What are the lending limits now? A: Most banks can lend somewhere between ten percent and twenty percent of their equity to a single borrower. Q: Based on the safety in diversity maxim, I suppose. A: Correct. If banks were held to lower limitssay two percent to five percent, they would be forced to diversify even more and their lending capacity would be spread more thinly over a broader spectrum. Q: Wouldn't that hurt the large borrowers? A: I'm surprised at your concern. Large borrowers generally have many sources of funds. Small and medium size borrowers have fewer alternatives and this policy would actually free up funds for them. Q: So you would favor this regulation? A: You're trying to catch me in the inconsistency of favoring regulation. Let me put it this way. If there has to be regulation, then limiting individual bank's exposure to large speculators and opening up capital sources for a greater variety of more modest endeavors, is one of the better regulations.

Q: I've heard it said that if insured banks had the same loss rates that they enjoyed prior to 1980 that they would have suffered only nine billion in bank loan losses in 1990 instead of $29 billion actually recorded. Is this true? A: Perhaps there is a clue in the fact that only one Canadian bank failed during the 1920s and 30s. Bert Ely, who has written a book for the Cato Institute which details the banking collapse in America in the early 1930s, attributes the relatively smooth sailing that took place over the same time period in Canada to the fact that ten banks operated four thousand branches throughout Canada. This gave Canada's banks a broad geographical dispersion for their banking risks. The independent bank, far from being the strength of small town America was its greatest weakness according to Mr. Ely. He believes the banking collapse in America in the early 1930s was caused, at least in part, by the restrictions on branch-banking which kept U.S. banks unnaturally small. In 1930 there were 23,700 banks and only three percent of them had any branches at all. In the early thirties the typical bank failure could be traced to fraud or a local economic disaster. Q: Interesting. A: Of the 4,800 bank failures during the Great Depression era, most banks were too small to carry on investment-banking activities and therefore there was really no justification, Mr. Ely points out, for enactment of the 1933 Glass-Steagall Act. Q: That's the law mandating separation of commercial from investment banking. Are other countries having banking problems or is this unique to the United States in the 1990s? A: Bank regulators from around the world met in Amsterdam at the end of 1986 and expressed their concern about the dangerous banking practices which they feared might have the potential to touch off a global banking crisis. According to L. William Seidman, Chairman of the Federal Depository Insurance Corporation (FDIC), bank failures increased from 49 in 1983 to 138 in 1986; 80 percent taken over by healthy banks and 20 percent liquidated. A report issued by the House Government Operations Committee in Washington DC, claimed of all the banks that failed between January 1980 and June 1983, 61 percent were involved in actual or probable criminal conduct. Q: Probable criminal conduct? That means a prosecution and sometimes a trial must take place in order to determine if the conduct was criminal. I'd also like to point out that 1,700 new banks were founded between 1981 and 1985.

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A: Many experts believe the nations banking system is resting on quicksand. There is a scary scenario that must be considered: the collapse of one large bank could lead to the failure of many more interconnected banks; business credit would then be constricted and surviving banks would be unable to purchase the bonds that major corporations depend on to finance their operations and expansions. It is possible that as desperate bankers try to stave off collapse, loans would be called, causing defaults and bankruptcies throughout the economy. Q: Not a pretty scene to contemplate. Listening to the dangers, one wonders how our banking system has survived as long as it has. A: The fact that it has survived should tell you something about the scare mongers. Between 1865 and 1933, before the government insured deposits, depositor-losses averaged only 0.78% of the total deposits in all commercial banks. Q: Before the FDIC? I thought there were all kinds of bank runs. A: In a study published by MIT Press in 1986, titled Perspectives on Safe and Sound Banking: Past, Present and Future, it was argued that costs imposed by bank failures and associated runs, were no greater than costs imposed by the failure of non-banking firms. Runs were examples of depositor discipline that shut down poorly managed and insolvent institutions. Q: You mean the market at work. A: I guess you might say that. But even though these losses were small, they nevertheless exceeded the losses of the FDIC between 1988 and 1989. According to the report, FDIC losses were approximately 0.25 percent of total bank deposits at insured banks or roughly one-third of the depositor losses experienced during the crisis years prior to deposit insurance. Q: If insurance cut the loss rate by two-thirds, you don't think anybody is going to want to do away with it do you? Besides, bank panics are contagious. A: The study showed that only two or three episodes before 1930 suggested any contagion as indicated by substantial increases in nationwide currency-deposit ratios and absolute declines in bank deposits. These researchers argue that the U.S. banking system was fundamentally sound prior to federal deposit insurance and was not prone to destabilizing banking panics. That was said by Jonathan Neuberger, Economist for the Federal Reserve Board of San Francisco on April 21, 1991. He also said, research suggests that banking markets are fundamentally stable and not prone to contagious runs." Q: What did currency have to do with it?

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A: In the early 1930s, frightened depositors irrationally converted their bank accounts into currency. U.S. currency is still the most widely used medium of exchange. Today there is more than $250 billion worth of currency in circulation and those who hold it don't have to worry about risk of default. Q: They do have to worry about theft or losing it. Credit cards and checking accounts are much more convenient and favored, I'm sure, by most people. A: In their 1963 study of monetary history, economists Milton Friedman and Anna Schwartz claimed that the monetary contraction of the thirties intensified the economic depression. They blamed the Fed for failing to pour reserves into the banking system. Q: I would imagine the lack of funds, led to the bank runs which in turn produced a credit crunch which acted as an additional drag on the economy. A domino effectright? A: That's one theory. In 1987 the FDIC insured 14,822 institutions with over two trillion in deposits, and for the first time since its founding, FDIC reserves of slightly more than eighteen billion were in danger of running out. The Federal Savings & Loan Insurance Corporation (FSLIC) which then insured thirty-two hundred Savings and Loan companies, was technically bankrupt as 1987 began. Q: Experts tell us that reforming the deposit insurance system is necessary for the health and long term profitability of the banking system. But I want to know how this is going to be done? A: Interstate banking and branch reform would help. Cost savings from mergers has been estimated at ten billion in pre-tax savings. Remember the industry earned only $24.5 billion before taxes in 1990less than an eight percent return on equity overall. Consolidation and interstate branching would help banks raise the capital they need. Over a five year period, the capital created from these savings could support more than $600 billion in new lending. Q: This is the way I see it: When OPEC money came pouring into this country in the late seventies it had to be recycled and the bankers decided that a lending spree to the Third World countries would do the trick. At the end of 1982 the nine largest U.S. banks had lent 146 percent of total capital, reserves, equity and subordinated debt, to Latin American borrowers. Not surprisingly, by the end of 1986 the list of problem banks totaled 1,484. Since not all banks acted irresponsibly, it only makes sense to determine capital requirements and insurance premiums according to the actual risks assumed by individual banks. A: The catch is not all risks are known or knowable. Q: But if they could be identified you can see how capital requirements at the higher-risk banks would encourage those banks to be more careful. Right?

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A: If is a tiny word but a powerful obstacle. This is not a simple problem. Off-balancesheet items are involved and then there's the interdependency of foreign banks, many unregulated, with U.S. regulated ones. To tell you the truth, I'd rather save a discussion of our interaction with foreign banks until a little later, if you don't mind. Q: OK. I'll backtrack. We talked about the FDICbank insurer. Would the same discussion apply essentially to the FSLICthe insurer of the savings and loan industry? A: Essentially. Since its beginnings in 1933, the FSLIC had supported itself with premiums from institutions it insured and with income from investments. Even though it had the authority to borrow up to $750 million from the Treasury, it never needed to do so before 1987. Q: That sounds like the taxpayers would be left holding the bag if the losses resulted in the institution's collapse. A: It is this open-ended liability with no limits to future costs which needs to be reconsidered. Q: Who had oversight? Any institution besides Congress? A: The FSLIC was controlled by the Federal Home Loan Bank Board which admitted that $6 million a day was going down the drain because of the sick institutions it was keeping alive in early 1987. Q: Why in the world was it keeping sick institutions alive? A: The 99th Congress was unable to pass legislation which would have pumped fifteen billion into the ailing FSLIC and would also have permitted regulators to sell failing institutions. Opponents argued that additional legislation wasn't necessary since many state laws already allow such sales. On top of that, the U.S. League of Savings Institutions incorrectly estimated the FSLIC would have $17.42 billion to cover pay outs over a five year period. Q: But if I remember correctly, the money requested was in the neighborhood of $25 billion. A: Right. Legislation to raise that amount over a five year period was put before the 100th Congress. Under the Treasurys plan the Federal Home Loan Banks would have sold debt, backed by zero-coupon bonds, for about fifteen billion over a five year period with an additional ten billion to come from income from other investments and special assessments on federally insured thrifts. What Congress actually passed in the summer of 1987 was considerably less ambitious. The banking-reform bill provided a $10.8 billion industry-financed package for the ailing Federal Savings and Loan Insurance Corporation, banned the creation of any more

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limited-service banks and prohibited banks from entering any securities businesses until March, 1988. Q: Why didn't they just combine the two insurersFDIC with FSLIC? A: Some people did suggest that merging the FSLIC with the FDIC would, back in 1987, have provided nearly twenty-nine billion to handle bank and savings and loan failures over the next five years without dipping into the corpus of the FDIC fund. Former head of the FDIC, William Issac, was not one of them, nor was his successor, William Seidman. Both men were against a merger. Q: How did bankers and savings and loan officers feel about a merger? A: Of course there were a variety of individual opinions but in general the commercial banks were afraid a merger might mean an increase in their deposit insurance premiums and would amount to the bankers' bailing out the thrifts. The savings and loans were not exactly overjoyed, fearing a merger might mean their ultimate extinction, or at least stricter controls. Q: That's chutzpah! It's not as if they were doing such a great job regulating themselves. A: I read in the August 1983 copy of California Lawyer that loopholes were tightened so it was harder for non-banking companies to acquire banks and run them as strictly consumer-banking organizations. In December 1983, non-banks were brought under the jurisdiction of the SEC by attempts to broaden the definition of lending to include the purchase of commercial paper, and the definition of deposits to include NOW accounts. Q: I remember some people questioned the idea that purchasing certificates of deposit should be equivalent to making a loan. A: In 1984, despite protests from the Florida Bankers Association, the Fed gave United States Trust Co. of New York, the go-ahead to convert a state-chartered trust company to a nationally chartered consumer bank. This was a first. Q: Why did the Florida group object? A: They felt the Fed's action violated the section of the Bank Holding Company Act which prohibits banks from owning non-banking entities. They exaggerated a bit and suggested that a local car wash or local bordello could now own a bank. Q: I've never heard of the Bank Holding Company Act? A: The Bank Holding Company Act of 1956 forbade holding companies owning more than one bank from operating in various states without express approval from the states themselves. In 1970 even one-bank holding companies were brought under the jurisdiction of the Federal Reserve Board. These regulations were a response to the rapid

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expansion of financial conglomerates, mostly based in New York. Legislation was pushed by members of congress from states such as Texas and Illinois where state banks weren't even allowed to open branch offices intrastate. Q: I remember when Bank of America was the largest bank in the world. A: In 1970 the ten largest banks in the world in terms of assets, were American. Now none are. Q: What do you think about the merger of BankAmerica and Security Pacific, two of California's largest banks, which took place in August 1991? A: For one thing it shows the pressure banks are under to expand in order to cut costs and counter the bad loans accumulated over the years. Expansion is their ticket to competition with the larger foreign banks. Q: Does that mean BankAmerica is now the largest bank, at least in this country? A: In terms of branches, 2,400 and ATMs, 4,000 you're right. But even with the merger, its assets are $190 billion versus almost $217 billion at New York based Citicorp. But although Citicorp has more assets than BankAmerica, BankAmerica is ahead in profits and is controlling its expenses The BankAmerica-Security Pacific merger is supposed to save about $1 billion in annual operating costs over a five year period. Besides, Bank of America has more equity capital than Citicorp. Q: And with its equity capital it can expand beyond the ten states in which it presently operates. A: Not only can, BankAmerica's CEO, Richard Rosenberg intends to expand his operation. In fact earlier in 1991 he was foiled in his attempt to purchase the Bank of New England (acquired by Fleet/Norstar Financial Group) which was especially attractive to Mr. Rosenberg who is himself a native of the Boston area. Q: Surprisingly it wasn't that long ago [1986] that Bank of America was itself almost swallowed by First Interstate bank. A: Just to show how life is unpredictable, on August 16, 1991 Richard Rosenberg addressed the San Francisco-based Commonwealth Club. This was only a few days after his bank's merger with Security Pacific. Q: Isn't Security Pacific the bank that sold some of its consumer and commercial service groups to Japan's Mitsui Bank in the summer of 1989? A: You're right. Mitsui reportedly paid Security Pacific $100 million for a five percent share, valuing the financial services businesses at fifteen times operating earnings.

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Q: That's unbelievably high. I suppose that's because banking analysts preferred regional banks like Security Pacific to money-center banks like BankAmerica and Citicorp. A: Possibly, and perhaps with good reason. Money-center banks were involved with bad loans to LDCslesser developed countriesan issue that was newsworthy and damaging a few years ago. In fact in the summer of 1989 federal regulators required a write down of some of those LDC loans which made the regional banks like Security Pacific, look good in comparison. Q: But that was then and this is now. A: That's astute! Mr. Rosenberg talked about the overcapacity of the American banking industry and predicted more mergers in the future between the larger banks. He pointed to his own just completed merger and to the Chemical Bank and Manufacturers Hanover merger which had taken place in July 1991 as examples. Q: Did he think mergers were a good sign? A: Yes, in as much as he saw overcapacity, along with restrictive legislation, as significant contributors to the competitive disadvantage American banks have been suffering in the global market. Q: If I recall, Richard Rosenberg took over the retail division at BankAmerica back in 1987? A: That's right. He had been the President of Seafirst in the state of Washington. He had turned down the BankAmerica job twice before. Q: He apparently has a reputation as a great marketer. A: Absolutely. He encouraged customers to use services beyond checking and savings accountssafe deposit boxes, IRAs, CDs, credit cardswhich all earn separate profits. Q: Many experts think Mr. Rosenberg was primarily responsible for turning around BankAmerica's fortunes. A: As you said, he is a great marketer. He used gimmicks such as giving away three years of free checking accounts to anyone who walked in the door of any Bank of America branch on a certain day, or if a new checking account was opened before a certain date the customer received coupons worth up to $1,200 at American Airlines, Hertz, Hilton and Carnival Cruises. Q: Aggressive marketing of banking products may be the key to the future success of banks.

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A: It's here today. Already consumers use banks not only as a place to deposit their money or for the convenience of checking accounts, but they purchase certificates of deposit, have payroll checks direct-deposited and can get cash through interbank ATM networks Q: You forgot to mention loans. Credit cards often make it possible to draw loans from a variety of institutions across the country. With a little work, consumers can find competitive rates. A: Not only that, competition has meant more convenience for consumers. Many banks now stay open forty-five hours a week instead of twenty-seven as was the norm just a couple years ago. Some are even open Saturday and a few hours on Sunday and others offer twenty-four hour phone information. Q: These services must be costly to provide. A: The costs are passed on to consumers who don't seem to mind as long as volume allows the banks to keep individual charges low. Q: The something for everybody principle. I understand that BankAmerica serves over five million households and has been earning over a billion dollars a year. A: That's right. It is reportedly the most profitable bank in the nation. In 1990 it purchased banks in Oregon, Arizona and New Mexico and now owns the largest in bank in California, Bank of America, and in Washington, Seafirst. Q: I heard that between 1987-1990 its consumer lending more than doubled from nineteen billion to thirty-nine billion. A: I know; it's amazing. Mr. Rosenberg had the thirty-one bank districts in California hold recognition dinners and sales rallies. The morale was high to the extent that each branch office had its own colors and unique branch cheers. Q: Sounds like high school sports or Amway sales rallies. A: The bank instituted incentive pay and recruited many of their current top management personnel from Wells Fargo bank. They managed to pare problem loans from five billion to three billion over only three years. Q: Is it true that most California banks pay less on consumer deposits than competitors pay in other states? A: I guess it is. In 1990 BankAmerica paid consumers only 6.7 percentthe consumers then paid the bank eighteen percent on credit cards and ten percent plus to borrow on the equity on their homes. Meanwhile Citicorp in New York paid eight percent. That saved

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BankAmerica seven hundred million and accounted for half its pretax profits. As we said at the beginning, consumer banking can be very profitable. Q: Not to mention the loss carry-forwards the bank had from its years of enormous losses. A: But these tax breaks, which are said to have added two hundred and forty million to 1990 net income, disappear in 1991. This, plus the recession may mean 1991 is a learner year. Q: I heard something about BankAmerica buying at least a dozen failed savings and loans from the Resolution Trust Corporation. [RTC is the government agency set up in 1989 to dispose of the assets foreclosed during the S & L fiasco of the late 1980s.] A: That may be. If you are worried about the possibility of a future monopoly, remember the numerous new nonbank companies. Q: It's hard to determine what institution is and is not a bank now days. A: It's interesting to see how that came about. Congress had defined a bank as an institution that accepts demand deposits and makes commercial loans. In a 1980 case, Gulf & Western Corporation substituted personal loans for commercial loans and viola, the first consumer bank was recognized. Q: Some people say we have too many banks for our population in this country anyway. Do you agree? A: I'd like to see the market place take care of that possibility. Mr. Rosenberg pointed out that American consumers are served by 12,600 commercial banks, 2,000 savings and loans and 16,000 credit unions. For instance Canada has 65 commercial banks, Japan has less than 150 commercial banks for a population of about 120 million people and Europe, with a population close to 320 million has about 3,000 commercial, savings and mutual banking companies. Our own commercial banks have been slowed while their competitors have been allowed to race around the course without any such handicap. Big Firms like General Electric, General Motors, Sears; none of them, or others like them that offer bank or bank-like products and services has to adhere to bank regulations or meet capital standards that banks must meet, or hold reserves at the Federal Reserve Bank, or most importantly, meet stringent Community Reinvestment Act requirements this despite the fact that these competitors are extending credit in direct competition with the banks. Q: It's my understanding that bank charters have been readily granted in the USA and until the late 1980s foreign banks were able to open branches anywhere in the country even though domestic banks were prohibited from doing the same thing in Japan. Correct?

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A: Japan doesn't allow foreign banks to develop money market instruments or manage mutual or pension funds in its country. The Japanese Ministry of Finance keeps interest rates low and gives Japanese banks their lower cost of capital. David Mulford, Under Secretary of the Treasury for International Affairs, said in early 1990, Basic deregulation, sweeping change or bold challenges to the way the existing system benefits traditional Japanese financial institutions are hard to find. Full deregulation is what is needed The failure by Japan to provide full access to its markets is particularly serious, given Japan's current financial and economic position in the world. Q: That doesn't seem fair. A: It gets worse. American laws allow foreign competitors to engage in the most profitable lines of banking business without carrying the same cost burdens of American banks. On top of this, our own commercial banks end up paying premiums that insure the brokered deposits of investment banks that cater to generally the most sophisticated financial consumers. Q: In addition to the expenses and costly regulations imposed on domestic lenders, foreign lenders have access to cheaper overseas funds. A: Exactly so. These foreign entities can therefore offer better interest. Is it any wonder they cornered thirty percent of the loans made to American business in 1991? There's no doubt American banking regulations benefit foreign competition. Thanks to the International Banking Act of 1978, approximately fifteen large foreign banks were exempted from the provision in the 1933 Glass-Steagall Act which prevents American commercial banks from underwriting corporate debt or equity offerings in the United States. This unfair advantage has contributed to todays situation where only one U.S. bank, Citicorp, can be found in the ranks of the ten banks with the most assets in the world. Last year a subsidiary of the Union Bank of Switzerland managed debt issues for BorgWarner Acceptance Corporation, Transamerica Financial Corporation and Allied Signalall in New York. Many foreign banks have been on a spree, buying shares in American investment banking establishments. Q: That's right. Not long ago Sumitomo Bank of Japan purchased a five hundred million dollars share in Goldman Sachs, one of Wall Streets more prestigious firms in order to break into investment banking in this country. A: To counter the ridiculous situation that allows foreigners to own banks in more than one state while making it illegal for a domestic bank to do so, in 1987 twenty states adopted reciprocal privileges. Q: Reciprocal privileges? What do you mean?

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A: Certain states allowed citizens of other states to own banks within its borders as long as the privilege was reciprocated. Q: Alan Greenspan, Fed chairman, said in April, 1990, There is reason to believe that the opportunity for a bank to diversify the products or services it offers or to diversify geographically may in some cases raise its rate of return and lower its risk. A: Well you can see something is being done about geographical diversity. Q: When are we going to do something about product diversification? A: Congress has been urged to pass legislation that would overhaul the Glass-Steagall Act and permit banks to engage in underwriting of commercial paper, mortgage-backed securities, revenue bonds and mutual funds. I remember when now retired Senator William Proxmire, was chairman of the Senate Banking Committee, he wanted to dismantle all or part of the Glass-Steagall Act. He saw it as a legacy he wanted to leave the country. Q: Why not allow capital-rich companies to affiliate and add their capital base to individual banks? A: It's the same old territorial scenario. Those that have a good thing going are never anxious for competition. David Silver, President of the Investment Company Institute, in his article for the April 1987 edition of the Financial Planning News, expressed a fear that Congress might be getting ready to repeat what he referred to as the disastrous 1927 McFadden Act. Mr. Silver suggested to readers that with recent sob stories about bank failures and the inability to compete, the same sensitivities are being appealed to that originally opened the way for the McFadden Act. Q: I can see where Mr. Silvers might prefer to not have the competition of federally charter banks. A: I wonder if there is such a thing as an unbiased viewpoint. We cannot escape our backgrounds and we shouldn't deny our legitimate interests. Q: Anyway I thought some commercial banks were already dealing in securities. A: Although commercial banks have been allowed to underwrite government guaranteed mortgage-backed securities, such as Ginnie Maes, they haven't been able to touch CMOs, as far as I know. Q: What's a CMO?

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A: Sorry. CMO stands for collateralized mortgage obligations. CMOs are bond-like securities backed by a pool of mortgages whose cash flows are repackaged to obtain securities of mixed maturities. CMOs allow investors and underwriters some protection against prepayments by mortgage holders. If Congress wont let them compete more freely, some banks may simply give up their banking charters so they will be free to diversify into other businesses. Q: Many of the nations largest banks have applied for an expanded role in the underwriting of securities. A: Underwriting involves purchasing securities in a block from the issuing corporations and selling them in smaller denominations to a variety of investors. In contrast to Mr. Silver, Federal Reserve Chairman Alan Greenspan believes commercial banks need more latitude in order to compete against freewheeling foreign institutions and Wall Street firms and therefore hopes Congress will overhaul GlassSteagall. Q: I've just got to tell you about a piece I read last summer in the August 26, 1991 edition of the Wall Street Journal. It was an article by Alan Murray in which he discussed the antiquated way we handle Treasury auctions in this country. Did you see it by any chance? A: If I did, I don't recall it. Q: According to Mr. Murray, the government securities market has always put the dealer above the customer. In the past Treasury has entertained fears that it might hold an auction and no one would show up. It was soothing to know the dealers at least, would bid in every auction. A: You mean someone at the Treasury Department is actually afraid the U. S. government might offer securities for sale and there would be no takers? Give me a break! Q: That was Mr. Murray's point. Such assurances are absolutely unnecessary in this age of instant global communication. He agreed there is no possibility that the U.S. government would be unable to sell its debt and therefore why do we need and pay for the expensive services of the forty primary dealersa n outdated luxury that should be phased out. He suggests we examine ways to improve the efficiency of the market, reduce the cost of financing the government's huge deficit so the taxpayer can have some relief. A: I think I might have read the article, now that you mention it. Didn't it have something to do with the Salomon Brothers scandal?

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Q: That incident was supposed to be the catalyst for a rethinking of the auction system controlled by the forty licensed primary dealers. A: Actually anyone can place competitive bids, but the bidding process is so cumbersome that few outsiders do it. The common bidders and large mutual and pension funds, route their bids through the primary dealers. This gives these forty dealers valuable information about how the large institutions are going to bid and is in itself a temptation to abuse, according to Mr. Murray. We take time to fume about underwriting by banks and ignore the manner in which over two trillion worth of government securities is auctioned every year. Q: Let me see if I've got this right. The Glass-Stegall Act prohibits banks from being principally engaged in underwriting ineligible securities. A: Right. But to show that they are not principally engaged banks have proposed ceilings to demonstrate that underwriting in no way makes up the principal part of their securities activities. At the end of 1986 the New York Banking Department, ignoring the old Glass-Steagall arguments that suggested the largest banks, if not severely restricted, could end up controlling industry, decided both J.P. Morgan and Bankers Trust New York could underwrite corporate equity and debt, commercial paper, municipal bonds and other activities formerly the sole province of the investment banker. Q: I bet investment bankers loved that! A: They claimed the states action would result in depressed underwriting profits for everyone and that new investment banking talent would be that much harder to attract. Q: And more expensive! Do you happen to know what is meant by the term universal banking? A: Universal banking is practiced in European countries, most conspicuously Germany, where banks are allowed to take unlimited equity positions in other companies. Japanese banks are only allowed a five percent equity share. By contrast, American banks are not allowed to engage directly in non-banking activities because their deposits are insured by the federal government and that would give bank-owned enterprises a distinct advantage over independently owned and operated entities. The market would eventually see to it that all businesses in the country were owned by banks. Q: It sounds like a choice between bank-controlled capitalism and stock-controlled capitalism. It also seems like Treasury's plan to allow banks to affiliate with non-banks under a common holding company is a taste of the former. A: Not at all, because under the administration's plan, the affiliate would not be protected by deposit insurance and fire walls would be erected.

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Q: In his Commonwealth speech, did Mr. Rosenberg specify other regulations that he felt were especially anti-competitive? A: He mentioned regulations that put a cap on the returns banks can make for shareholders and the limits on the kinds of products and services banks can offer consumers. He suggested a repeal of the restrictions on interstate branching and reiterated the need for a recapitalization of the Bank Insurance Fund (BIF) within the Federal Deposit Insurance Corp. (FDIC). Q: Did he volunteer how he might like to see the recapitalization come about? A: Nothing really that we didn't already hit on in our discussion. He cautioned against increasing the premiums to such a degree that marginal banks would be unable to pay and healthy banks might find their earnings too severely decreased. Q: I believe the Bush administration is loathe to decrease the profitability of banks via high insurance premiums and capital requirements. I've read elsewhere that for every dollar a bank pays in premiums to the FDIC, fifteen dollars are removed from its lending inventory. A: I think Mr. Rosenberg mentioned something like that also. He advocated a free market in banking which would, he said, give consumers a wider choice of financial services and products at competitive prices than anything dreamed up by legislators. Q: Not only that, there's safety in the diversity now prohibited by Glass-Steagall. A: Absolutely. As we said earlier, there's safety in geographical as well as investment diversity. Q: According to Randall Pozdena, in an article for the Federal Reserve Bank of San Francisco Newsletter, there is a difference between the way leverage is viewed and used by private corporations and the banking industry. In a corporation, increased leverage (greater debt to equity) raises the expected return (earnings per share) to shareholders which makes those shares more valuable. On the other hand, reliance on debt weakens the private firms ability to survive fluctuations in asset value without default and subsequent bankruptcy. A: Of course tax policy distorts the picture somewhat since interest payments on debt are deductible against corporate income and dividend distributions whereas retained earnings are not. Q: I've heard that most U.S. banks are already overcapitalized relative to the risks to which they are exposed. A: A bank has an incentive to either guarantee all of a loan or to retain the loan and the related exposure. Therefore, while there may be far too much capital in the banking

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system as a whole, there may be far too little to protect the FDIC from experiencing catastrophic losses in a severe nationwide recession. According to financial consultant Lowell Bryan, having everyone raise more capital is not the answer. The problem lies with specific institutions, not the entire industry. Q: As you yourself have said, Congress has over and over again shown its propensity for blanket legislation rather than targeting needs. The problem is the commercial banks would be risking depositors money. As legislators see it, the challenge is to restrain the enthusiasm of bankers and see that their greed is tempered with good judgment in order to avoid results similar to those which came from their earlier plunges into real estate, energy and overly optimistic loans to lesser developed countries. A: The third phase of the Depository Institutions Deregulation Act of 1980, loosening restrictions on banks and savings and loans, was set to take place in 1984. However it was overshadowed by a proposal from the Task Group on Regulation of Financial Services which was headed by then Vice President George Bush. Q: What proposal? A: The plan announced in late January 1984 was to replace the comptroller's office with a newly created Federal Banking Agency within the Treasury Department. It would have had jurisdiction over most of the then 1,425 federally chartered banks and their parents. Q: What do you mean most? Are there some banks they wouldn't have controlled? A: The fifty largest bank holding companies would have continued under the jurisdiction of the Fed which would have also acquired jurisdiction of the nine thousand statechartered banks then regulated by the Federal Deposit Insurance Corporation. The Fed could have certified individual banks and release them to the jurisdiction of state agencies. Q: I never heard about this. A: The gang on Capitol Hill kept it from seeing the light of day. Q: Well, I'm grateful to those who blame deregulation for the massive savings and loan bailout and banking troubles that loom over taxpayers today. What do you think? A: I'm always for as little regulation as possible and more decentralization of power. But when institutions do a lousy job regulating themselves, government steps in. Regulating is the easy part; everyone loves to tell everyone else how to act. The hard part is deregulation. A lot of people have a stake in maintaining federal and local regulation. Deregulation on the other hand, is like moving a mountain. Q: John F. Kennedy gave deregulation a try when he was president.

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A: But it took the OPEC created inflation of the 1970s to give it any kind of momentum. In the seventies the airlines, trucking and finally financial institutions were deregulated. Q: I thought Regulation Q was in effect all during the seventies. A: Regulation Q was a prime example of unhealthy interference by government. If you remember, banks, under Regulation Q, were only permitted by law to pay five to five and a quarter percent to depositors when the prime [most favorable interest rate] was as high as twenty-one and a half percent! Inflation meant that savers were getting less real dollars back than they put into the banks in the first place. Usury laws kept credit cards at eleven or twelve percent in some cases when borrowing elsewhere cost eighteen to twenty percent. When deregulation overtook Regulation Q it was way overdue. Restrictive monetary policy had driven interest rates up and depositors had left banks for higher-yielding, unregulated money-market accounts. Q: When was Regulation Q dismantled? A: The interest rate ceilings imposed by Regulation Q were removed in 1982. Competitive banks immediately began paying depositors interest rates far in excess of the risk assumed. Q: Risk assumed? With deposit insurance, there was no risk assumed. A: That's the point. Government in effect subsidized those interest payments to depositors and allowed the banks to offer overly generous loans to borrowers. Q: They could do that because technology had allowed them to raise deposits around the world and they were unable to use those deposits for anything beyond the loan business. A: That's right. The Glass-Steagall Act still keeps the big commercial banks from underwriting corporate securities in this country and competing with the investment bankers. If a transaction is successful the bank is often able to make money from the management fees and also from the profit on the deal itself. The difference between the additional-fee-income and interest-income alone explains why investment banks enjoyed an average return on equity of twenty-six percent 1983-1985, while commercial banks had to settle for an average return of fourteen percent. But these off-balance-sheet deals stretch the banks capital in ways the traditional ratios fail to measure. Q: No wonder they sought high returns through high-risk lending to Third World countries and to commercial real estate developers. A: You're right. The discipline of a free market was removed and speculators had a field day.

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Q: Most politicians tell it the other way: regulation was removed and speculators had a field day. They still haven't realized that government regulations cannot control market forces. Government regulations just mess things up. A: The trouble is, when one speaks of market forces in financial matters, one better be prepared for booms, busts and their accompanying panics. The debate should not be whether we rely on regulation or marketshistory shows unregulated financial markets self-destruct. Problems arise when we try to use regulation to control market forces that are beyond its control and in the process create flaws that skew the marketplace. Barney Frank of Massachusetts is, in my opinion, one of the most brilliant men in congress. He showed that he knows darn well what is going on when he reminded fellow members of the banking committee that: As you measure something you may be affecting it. As you regulate something you may be affecting it. We ought not to pretend that the regulation is simply a neutral look. Regulation is a calculation of risks. We under calculated the risks of lending and under calculated the damages of too little lendingwe need to balance the two. Q: It's only too bad that he has more faith in the ability of inexperienced legislators to calculate risk than he does in experienced bankers and investors. He obviously prefers regulating to market forces. It seems to me that congress, instead of reforming the deposit insurance system, is simply increasing the power of regulators and examiners to determine who gets credit and who doesn't. A: You're right. When the losses from depressed real estate are tallied it is possible that 40 percent of all deposits will be in undercapitalized institutions. Therefore how these deposits will be lent will be controlled by regulators rather than management and shareholders. Naturally each participant will find ways to exploit the particular rules that apply to him or her. Strong banks will search for loopholes in Glass-Steagall and for states that will allow them to do things not allowed by federal law. Non-bank financial firms will continue to sell bank-like products (money market mutual funds, credit cards, home equity loans) with a different set of rules. Instead of making market and economic and competitive forces work better, this narrow reform will distort those forces. It won't be the quality of service that gains market share, but exploitation of rules. Q: It has recently been suggested that instead of reviving Regulation Q with its inflexible ceiling on interest rates, that maximum interest rates on deposits be raised to the market interest rate on Treasuries. What do you think? A: As long as legislators are determined to dictate to the market this proposal would at least avoid the drain on banking that occurred under Regulation Q whenever the market rose above the old inflexible mandated rates.

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Q: The average citizen has been pretty much brain-washed by media coverage and almost to a man and woman believes deregulation has been the cause of most of our problems and must at least share the blame for the recent instability in the U.S. financial system. They honestly believe that deregulation encouraged banks to venture into risky activities that they often knew little or nothing about. A: I grant you, the present trend is away from removing regulatory oppressions and toward the imposition of new safeguards aimed at ensuring the safety and soundness of the banking system. Q: Now who could be against ensuring the safety and soundness of the banking system? A: Exactly! Deregulation is a chicken or the egg question. Which is the cause and which is the effect? Q: For you maybebut as I've said, I think it is settled in the minds of most citizens and deregulation has been awarded the black hat! A: Did you know that Islam forbids the payment of interest? They have a profit-or-loss system where the borrower and lender make an agreement that delineates the way in which profits or losses are to be shared between the two parties. Q: Sounds like an equity position where the lender becomes owner of the venture by agreeing to share in losses as well as profits. A: That's an interesting way to look at it. I like the fact that risk is transferred to the lender, which makes the lender more careful about the endeavors it finances. This emphasizes productive investments. Q: That makes sense. I would expect lenders to become involved in a venture where they have placed money and to do their best to make it work. They essentially become team players. A: The banks' balance sheets would show equity positions on the balance side and the liability side would look like a listing of shares in a mutual fund. Instead of depositors, there would be shareholders and their returns would vary with the banks' returns. There would be no need for deposit insurance and no fear of runs on the bank. Q: It is doubtful that the banks would have so easily lent money to LDCs if the return on the investment depended on the success or failure of the project for which the money was requested. A: Also if depositors viewed themselves as investors with money at risk, they would shop in order to put their dollars in the bank with the highest profit and least risk. Sound management would be rewarded and encouraged.

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Q: And banks would be forced to find the most promising investments in order to attract depositor-investors. Hey, do you think we've hit on something? Do you think America's commercial banks should forget about earning interest and become equity-based financial institutions? A: I realize you're joking, but I really think a trend in that direction should be encouraged. An interim suggestion was tendered by Mohammed Alacem, associate professor of economics and Middle East editor of Economic Forum in an article published in the May 9, 1991 Wall Street Journal: Depositors could make standard deposits that are federally insured up to a reasonable limit or could open an uninsured mutual fund account. Allowing financial institutions to play a dual role would give a much larger sector of the U.S. population access to mutual funds. The exposure of the (FDIC) would diminish as more depositors become more savvy and open accounts in the mutualfunds side of the bank. Q: That would stifle the entrepreneurial spirit. A: What do you think tight credit does to the entrepreneurial spirit? Since marginal projects would not be easily financed, there would be fewer failures. A little caution should not be the death knell of the entrepreneur. It could help to ensure a greater percentage of successes, which ain't all that bad! Q: A great theory but A: Ok, I admit there are abuses. Q: Sure, instead of making interest on a car loan, the Islamic bank purchases cars outright and sells them to would-be-borrowers at a profit. If payments are made in installments, this is merely a disguised interest payment. A: There are no perfect solutions but I think we should be looking for new and better ways to do things. I'm not advocating wholesale adoption, but we can pick and choose from a variety of ideas to upgrade our present system. Q: I agree that we can't afford to be complacent when in FY1991 the FDIC paid out $66.6 billion and is expected to disburse $100 billion or more in 1992. A: Add on the seventy billion loan to the BIF (Bankers Insurance Fund) and there is a liability of two hundred and fifty billion in future outlays just to pay off depositors. Q: That's what I mean. There are no constituents for this item in the budget. Everyone would like to see it fall to zero.

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A: Falling real estate values will trigger more failures by thrifts, banks and insurance companies. Depressed real estate values lower the value of loans and securities collateralized by real estate which represent about thirty percent of bank, insurance and other financial institution portfolios. Q: Not to mention that real estate makes up one third of household net worth and contributes in varying degrees to the net worth of businesses. A: Don't overlook the fact that commercial real estate is responsible for about twentythree percent of all the taxes paid in this country. Q: More than seventy percent of all local taxes collected. A: That's right. Real estate values have an enormous impact on every community. Q: Furthermore, as far as I can tell, every economic recovery in the post war period has begun with real estate. This is serious stuff! How did we let this mess happen? A: There's no one thing or person to blame, but it's fair to say the 1981 tax cut created excessive incentives which contributed to the overbuilding of commercial real estate. Q: On the other hand, the 1986 act overshot and knocked the props out of real estate prices by taking risk capital out of the industry. A: That's right. Then some people claim inadequate regulation was the cause of the overaggressive lending which led to inflated prices and overcapacity. Q: Enough with the problems and reasons. What's the cure? A: We need to stabilize real estate values to prevent the failure of more institutions. Q: How? A: To get the industry moving again I believe we need a combination of lower interest rates, regulatory policies that allow sound real estate financing, and a federal tax program aimed at stabilizing and restoring commercial and residential real estate values. The Fed has been attempting the first step by lowering interest rates but long term rates need to come down further. Secondly some of the lavish criticism that has been directed at both lenders and regulators needs to be curtailed. The constant blame has led to paralyzing fear. The Fed and regulators should assure lenders they will not be penalized by financing sound real estate investments.

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And hardest of all, because next year is an election year and partisan politics will be in full swing, congress should restore some form of passive loss treatment, cut the capital gains tax and expand incentives for low-income housing. Q: I'd advise some caution there. Existing commercial properties should be favored over new constructionfor residential there should be incentives for new construction. A: Stopping the decline of real estate would restore confidence and health to the capital markets. Q: The inevitable questioncost? A: What such a program would cost in foregone taxes would be made up in fewer bail outs. Shortly after the passage of the 1991 FDIC reform act, Timothy Ryan, head of the RTC [Resolution Trust Corp.] told examiners not to write assets down to liquidation value. Q: I bet that didn't sit well with Henry Gonzalez, chairman of the fifty-one member House Banking Committee. A: You're right about Mr. Gonzalez wanting to counter this go easy approach he felt was being urged on bank examiners. After all, congress had just passed rigorous regulations, not geared to help Mr. Bush's re-election, so it is likely that Mr. Gonzalez thought members of congress were kept from the Baltimore meeting of bank examiners, which took place at the end of 1991, for partisan reasons. Q: I've observed his banking committee in action and it is evident that Mr. Gonzalez wants to see full disclosure of any banking industry problems. He believes the practice of sweeping problems under the rug, is what led to the current Savings and Loan fiasco. He has gone on record as anticipating a banking crisis in the 1990s to mirror the Savings & Loan crisis of the 1980s. A: That's right. He advocates early intervention and prompt takeovers. His zeal can, in my opinion, be dangerous and lead to premature and unneeded bank closings. Q: You've got to admit there were an inadequate number of regulators in the. Ronald Reagan cut them back and went to off-site monitoring using computers and other technology. A: Joel McLemore, was an FDIC examiner from 1976 to 1986. He wrote an article published in the Wall Street Journal on December 5, 1991. He revealed some of the temptations, and often shady practices, of bank examiners on their way to the top of their profession. Bucking for a promotion led to some over zealous determinations. He suggested that most field offices have at least one hard-nosed examiner who put the burden to prove asset quality on the bank.

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These examiners enforce exacting standards that few banks can achieve. While one excessively ambitious examiner in ten might not sound like much of a problem, bear in mind that these examiners seek to do more examinations than others. Q: When a few large, mostly adequately secured, real estate loans are classified as substandard, even though risk of loss is minimal, the perception of the public and legislators is skewed. Unfortunately individuals, companies, and in this case bankers, simply sit back and take it from their government. The feeling of powerlessness against government is becoming all too pervasive in today's society. That's why I like the prescription Mr. McLemore proposed for bankers. A: What was that? Q: He said: Few banks bother to contest inaccurate [loan] classifications on the mistaken assumption that such protests are futilea thoughtful proof that a classification was substantially incorrect will receive consideration. That proof might be sufficient to preclude some forms of corrective action, as agencies are sensitive to charges of unfair practices. A: I want to take a minute to relay an example of what is going on in this regard by referring to an article by Daniel Clemente, a real estate consultant in Virginia, which appeared in the November 4, 1991 issue of the Wall Street Journal. Mr. Clemente told the tale of a real estate development started in 1986 and aborted in 1990 after the first phase of 318 homes had been completed. Mr. Clemente was a consultant to the bank which acquired the uncompleted portion of the project in the spring of 1990. His firm determined that to maximize the return on the sale of the land, it would be prudent to complete the engineering work. This would enable us to obtain final site plan approval for the subdivision of all land in phases two and three into building lots. . .because the approval process is so lengthy, taking property to final approval adds great value to the property. The bank was advised to complete construction of the sewer line but before this could be accomplished the RTC took over the institution and decided not to go ahead with any work on the described property. Consequently a year later the RTC (taxpayers) held 213 acres of land with no access to sewer lines which will have to be marketed as acreage rather than lots. In the meantime the preliminary plan approval granted by the town is about to expire. Since the original preliminary plan was approved, the town has altered its design standards for public facilities. Engineering to meet the new design standards will cost an extra $440,600money that could have been saved had the RTC finished the job back in 1990.

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Mr. Clemente went on to say that eleven neighboring property owners and the town itself had made agreements to shoulder some of the costs of the sewer system but the RTC delay voided these agreements. Instead of costing $768,998 the sewer lines could now cost $3.5 million! Q: Well I imagine that will drag down the selling price of the property. A: When foreclosed, the property was carrying $16 million worth of debt so you know it was valued much higher than that. It is predicted to net the RTC somewhere between $3 and $4 million. If it had been managed well and $1.5 million had been invested in engineering and review fees and sewer construction, Mr. Clemente suggests it could "reasonably be expected to yield in excess of $22 million." Q: It's easy to see that if nothing is done; the downward spiral in the value of real estate will accelerate, precipitating the collapse of commercial banks by undermining the value of property held as collateral and eroding the principal element of every American family's net worth: the equity in their home. Real estate is a substantial portion of the nation's net worth and it has declined by about forty percent between 1989 and 1991. A: It would be helpful if bank regulators stopped forcing banks to write down assets to their artificially low present values when they have real long-term much higher value. Q: There should be no need to value assets at bargain basement prices as long as the property is showing adequate return. A: If bankers were left to make their own decisions, I agree with you that they might not need to mark property to market as long as it was carrying the loan. Stocks, bonds, property and other fluctuating assets do not lose value unless they are sold. But most legislators know nothing about these things and value their own power above everything else. Q: Does all the money Congress gives to the RTC go directly to depositors in institutions that have been closed? A: The RTC doesn't use the money Congress gives it to pay back depositors, It uses the money to purchase the bad assets of insolvent savings and loans. Q: I've heard William Seidman say an asset looses twenty percent of its value the minute the government takes possession. A: That is the justification for providing subsides to those who purchase failed institutions and their undesirable assets.

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Q: I get it. The lesser subsidy saves the twenty percent that would be immediately lost if the RTC were forced to possess the bad assets instead of selling them with the institution. A: Lamar Kelly, deputy in charge of asset disposition, said the RTC has sold more than half of the assets seized in 1991 and in the first eleven months had raked in close to eighty-one billion. By the way, did you know there was a drafting error in the legislation authorizing the RTC? Q: I suppose you'd fall over if I said, sure I knew it all along. Let's just say I'm not surprised. A: The original legislation in 1989 allowed the RTC to borrow working capital totaling more than one and a half times its assets. Q: You mean there is a perverse incentive to hold on to assets rather than sell them? A: The more assets the RTC manages the more fees it is allowed to allocate, thanks to the 1989 drafting error. Every time the RTC sell something, that sale reduces the amount of working capital the agency can borrow. Q: How about putting a cap on the number of assets the RTC can have in conservatorship and on its number of employees? A: That has been suggested. It's always amazing to me how legislators consistently overlook human nature when drafting laws. It is not shameful and it should be no secret that people act in their own self interest. Why can't our legislators take this fact into consideration? Q: I would imagine you would have something to say about the law which requires savings and loans to deduct from their capital any direct investment in real estate. A: What can I say? An amendment to grant temporary exceptions to this legislation and another to decreased the amount of capital a S & L must hold for certain homeconstruction loans and for high-quality seasoned apartment loans, were deleted by the Senate, after passage by the House and before the final vote on the bail out bill in November 1991. Q: And speaking of that bailout billI understand it was trimmed from the $80 million requested by the RTC to only twenty-five billion. Correct? A: That's right. The bill was finally passed on a voice vote in the House and it was the last vote to be recorded in the Senate, (44-33) after many members had left for the 1991 holidays. Since the additional funds are only supposed to hold the RTC until April 1992, more legislation in this area is on the agenda.

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Q: Have you heard of bulk sales? A: Sure. That refers to the practice by the RTC of selling several properties to one purchaser. In these transactions the government typically provides the financing and receives a portion of the cash flow and the proceeds from any subsequent resale. At least twenty-five percent of the real estate included in such deals is supposed to be unprofitable. Q: I've heard the practice of combing unprofitable with profitable assets referred to as bundling. A: That's what I'm talking about. These bundles are sold at a discount and saves the RTC, and ultimately the taxpayers, money. A quick sale is better than incurring the holding costs for managing the bad assets for a long period. In 1992 the RTC hopes to sell a hundred billion worth of assets with almost one-third bundled. Q: But when you offer property for sale, all cash, at bargain basement prices, who do you expect to attract as buyers? A: I get your point. We're back to that old axiom I learned as a child, "Those who have, get." Q: You're not kidding! Guess what happens frequently to those deposits we were discussing earlier totaling more than a hundred thousand dollars? A: I know what happens. These overly large, and therefore uninsured deposits, are protected as a matter of policy if a bid has been received by the RTC that would be less costly to the insurance fund than liquidation. Q: In early 1987, Vernon Savings and Loan in Texas reported $1.35 billion in assets but about $1.7 billion in liabilities. The trouble, according to a report of the Federal Home Loan Bank Board, was imprudent and risky lending practices. Since losses are usually double the amount of a failed institutions negative net worth, in Vernons case the loss was estimated at about $700 million. A: In the summer of 1986 federal bank regulators decided to spend $130 million to salvage the failing Bank of Oklahoma; only the eighth bank to be saved since 1933. First Republic Bank of Dallas, which was formed in 1987 by a merger of Republic Bank and Interfirst, in 1988 turned to the federal government for relief. Reportedly sixteen percent of its loan portfolio was bad, leaving bond holders and shareholders at risk. Q: I remember in 1988, First Republic was the same size as Continental Illinois was at the time of its rescue by the federal government in 1984. But I'm confused. I thought the FDIC only protects the bank's depositors.

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A: That's generally true but FDIC protection didnt stop depositors from withdrawing six hundred million from the bank in the first quarter of 1988. We enter the dialogue to hear a discussion of the problems associated with government regulation and bank failures. Q: Didn't Professor George Kaufman of Loyola University in Chicago come up with a plan calling for quick closure of troubled banks while there are still resources to pay depositors and creditors when the banks net worth is zero rather than sub-zero? A: Timely closure would allow more equal treatment of banks regardless of their size, location or nature of their business. Q: Does that mean no bank would be too large to fail? A: It may have meant all banks, large or small, should have help to survive. I see the challenge as not to eliminate bank runs, but to harness consumer power in such a way that the financial system will be both safer and more efficient. Q: First National Bank & Trust Co., Oklahoma City; M Corp of Dallas and First Republic, Texas and Bank of New England were all considered too-big-to-fail. Their size made it highly unlikely that they would be purchased and absorbed by other banks. A: Well keep in mind that it cost less than a billion dollars or about 3.5 percent of the FDIC's total insurance losses during a five year period to protect the deposits that exceeded the $100,000 insurance limit in those institutions. Q: Economists fear that a large bank failure could result in adverse macroeconomic consequences and instability in the financial system. A: Don't get over dramatic. After all about ninety percent of small-bank failures are resolved through P&A, purchase and assumption transactions. In a P&A, all the deposits are assumed by a healthy take-over bank. Of the 169 banks that failed in 1990, only twenty were resolved through a payout of insured deposits. Naturally a P&A is less costly to the FDIC than liquidation. Q: Are you saying it is impossible for large depositors to lose now days? A: That's not what I am saying. The National Bank of Washington (NBW) failed in August 1990 and all depositors were protected, but when the minority-owned Freedom National Bank folded, depositors with accounts exceeding the $100,000 FDIC protection limit were losers. Q: That sounds suspicious to me. It sounds like the depositors in NBW had clout. Who were the depositors at Freedom Bank?

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A: There were people with clout. Included were the United Negro College Fund, the National Urban League, many churches and the campaign committee of Democratic Congressman Charles Rangel. But it wasn't a matter of clout. NBW had deposits of $1.1 billion and was too-big-to-fail whereas the deposits of Freedom National totaled only $91 million so regulators apparently figured its liquidation wouldn't damage the banking system or the nation's economy. Q: So Freedom's big depositors lost out? A: I said the decision not to pay the large insured accounts was not based on clout but I didn't say clout didn't play a part in the outcome at Freedom Bank. The New York congressional delegation pressured the FDIC so at the end of 1990 it announced that it would pay off about half of the fifteen million in Freedom National's uninsured deposit claims. Q: Let's cut to the chase. The concern is that the federal government, meaning taxpayers, may end up bailing out all the banks. A: Absolutely. You can bet there will be more banks as well as savings and loan bail outs in the future and the FDICFederal Deposit Insurance Corporationmay not be able to afford to pay off all the insured accounts. Q: So here we are at the end of 1991. Legislation was actually passed in November which included strict capitalization requirements and higher fees to finance the seventy billion replenishment of the FDIC. [The FDIC Improvement Act of 1991.] We got an FDIC bailout measure without the hoped for banking reforms which would make banks more profitable and competitive. Proposals to allow banks to establish branches nationwide and to engage in insurance and securities operations with the flexibility now allowed many other financial businesses were tossed. Compare the reality to the hopes circulating earlier in the year. A: A variety of proposals were circulating. Under one Treasury proposal, regulation of government-backed insured banks would have been increased and the activities that could be carried on inside the bank would have been limited. Riskier activities would be carried on in separately capitalized entities not backed by the FDIC. The proposal required risk-based deposit insurance premiums and emphasized the need for adequate capital while allowing for supervisory early intervention in undercapitalized institutions. Then there's the Rinaldo Amendment to H.R. 6, the Deposit Insurance Regulatory Reform Act of 1991. As argued in the fall of 1991, the amendment would have allowed commercial non-banking entities to purchase failed banks as long as they put in the best bid. Q: Last summer [1991] I heard ninety-six failed S & Ls had already been purchased by non-banking entities with no problems. Right?

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A: That's true. However banking committee members John Dingell, Henry Gonzalez and Jim Leach all were adamantly against the Rinaldo Amendment. Mr. Dingell complained that it would set up two categories of banks. Paul Volcker, former Federal Reserve chairman, testified before the committee. He expressed fear that such a concentration of power in the American economy would be bad for banks, bad for business and bad for consumers. He felt finance-commerce combinations could be costly to stockholders and not in their best interests. Q: No takers, eh? A: That's not true. William Seidman, former head of FDIC and RTC (Resolution Trust Corp.), argued that allowing this additional source of capital would reduce the eventual cost of the bailout for taxpayers. Representatives Norman Lent and Barney Frank thought that anything that would save the taxpayers money was great. In the spring of 1991 I brought up the plan that I told you about earlier that was proposed in 1984. Q: You mean the proposal to create a new Federal Banking Agency inside the Treasury Department? A: Right. Remember the new agency was supposed to oversee savings and loans and federal banks while the Fed would oversee state banks. William Seidman, then head of the FDIC, was highly critical of the proposal. But then you have to realize the FDIC, his agency, would have been stripped of its regulatory power and been reduced to merely accepting deposit insurance premiums and paying claims. Q: "Then head of the FDIC"? Does that mean he has been replaced in that position? A: In October, 1991, William Taylor became Chairman of the FDIC. You might be interested in a press conference held in December 1991 by the Shadow Regulatory Committee consisting of George Bentson of Emory University, Kenneth Scott of Stanford, Edward Kane of Ohio State University, George Kaufman of Loyola, Franklin Edwards of Columbia, Paul Horvitz of the University of Houston and Scott Aspinwall. Q: What in the world is the Shadow Regulatory Committee? A: The Committee was set up to make recommendations regarding banking reform. Members discussed minimum capital ratios, the too big to fail concept, disclosure and other regulations and concluded that the government agencies have to make the actual decisions. Q: Oh well, that conclusion justifies the effort of setting up a committee. A: Hold on! Professor Edwards thought some relaxation of expensive, useless SEC disclosure rules was in order; scandals occur regardless of regulation. He considered

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markets to be the best regulators and thought the FDIC should review regulation vis a vis foreign markets and competitors with the idea of allowing foreign stocks on U.S Exchanges. There seemed to be a consensus for diversity and a recommendation to expand bank branches nationwide. It was suggested that Glass-Steagall be repealed and banks be allowed to sell insurance and so forth. According to Professor Bentson, We weakened our banking system and now won't give them powers to serve the public because they're too weak. Professor Kane claimed, Thirty billion won't be enough. Q: I thought sixteen billion was budgeted in 1991. A: That's right; and ten billion in 1992, eight billion in 1993, seven billion in 1994 and less in 1995 and 1996. These are not full costs. There is a need to oversee the government overseer. The members of the Shadow Committee agreed that contingent liabilities need to be considered and a fair market value assigned to them. Professor Kaufman pointed out that there was no failure of really large banks before FDIC. Diversity and lots of branches prevents failureonly when the bank was small and localized and dependent on a small local economy did they fail. Q: We discussed that earlier. Paul Muolo, author of Inside Job: the Looting of America's S & Ls, thinks banks shouldn't be allowed to engage in securities underwriting which has long been outlawed by the terms of the Glass-Steagall Act anyway. He doesn't believe the Treasury line that the reason banks aren't making profits is that others are stealing their business. He claims that if banks are losing lines of business to money market funds and securities firms that make bridge loans, maybe it's time to impose reserve requirements or other restrictions on those companies. They benefit from sales to the public but don't pay deposit insurance premiums. A: Well Mr. Muolo should be happy with the passage of H.R.6. Many members of the Shadow committee were not. Professor Scott asked, "Is it worth two hundred billion to ensure no losses for any depositors ever?" He told his listeners that we had choices in this country up until 1964 with no problems. Q: That's not exactly true. A: I guess it depends on how you define trouble. He mentioned the tendency of those that are in to make it tough for those that are out." Q: When are we going to learn that government regulation does not workhas not, will not and cannot! A: The same abuses that destroyed the S & L industryrisky investments, self-dealing and accounting shenanigansare now showing up at insurance companies.

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Take Guarantee Security Life Insurance Company in Florida whose recent collapse left many of the fifty-seven thousand policyholders in forty states defrauded. Guarantee paid lavish commissions to get independent agents to sell their policies, offered low minimum premiums to folks of modest means shopping for security and paid ultra-high interest rates to attract investor dollars. Of course they ended up playing the junk-bond market in order to pay the exorbitant interest offered. Because state law limited insurer's exposure to junk bonds to 20 percent of assets, the company temporarily swapped, at least on paper, hundreds of millions of dollars of junk bonds for U.S. Treasuries. Q: It sounds like they had something up their sleeve besides safety. A: You've got it! Government regulations exempt companies who invest in Treasuries from setting aside reserves to cover potential losses. Q: Why didn't regulators spot these problems and prevent the collapse? A: Way back in 1986 state examiners noticed big swings in Guarantee's portfolio, but they failed to understand their significance. Four years later Guarantee was in such bad shape, with the collapse of the junk bond market, that it curtailed writing new insurance policies. The state postponed a scheduled examination and by the summer of 1991 it was all over. Q: What did the insurance commissioner have to say? A: There were things that should have caused us to look into things earlier and more indepth. Obviously, if I could do it over, I'd do it differently. Q: I think the commissioner's statement highlights the inability of state regulators, who are simply not sophisticated enough to spot problems when complex deals are involved. The people conducting exams and those supervising them are no match for elaborate white-collar schemes. A: I think this is another example of government action causing the problem. The changes in the 1986 tax law, especially in reference to capital gains, dealt the death blow to speculative bonds; junk bonds. But only after government action made certain they became junk. This really infuriates me because it is repeated over and over in all segments of our society. If bankers listened to legislators they would find themselves in the same straits as those jumpers dangling at the end of a bungee cord, jousting now this way now the other. Q: I happen to agree. Washington has been giving conflicting signals and inconsistent messages heaped on top of natural fluctuations in economic cycles can, and has, spelled disaster.

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A: During good times bankers can safely lower their lending standards, safe in the knowledge that any poor lending decisions will be redeemed by the rise in the price of assets. In bad times, even good decisions are marred by the possibility that a drop in the price of assets could make an otherwise well secured or well considered loan risky. It's a round robin with the credit crunch spawning more hard times, creating a greater contraction of capital which in turn produces more hard times and so forth. Tight credit, called loans, and deflating asset values all add to the problem. Q: I would think this would be the time to retire debt or at least refinance when interest rates are low. A: Many businesses are doing just that. But when they buy back their debt they don't use the newly created liquidity to expand and upgrade. This means that in hard times the economy is denied the shot in the arm it so desperately needs. Even individual consumers adopt more frugal lifestyles. Q: This hurts restaurants, hotels, and the retail and the leisure industry. It's no longer acceptable to simply standby and let the market purge inefficient businesses. This creates a clamor for more government intervention even though benign neglect may be the best course. A: And even though government intervention may have been the main culprit in the first place. Q: Not only that, in 1991 as corporate and individual debt went down government debt increased at an accelerated rate. The federal deficit just for one yearfiscal year 1992 w as predicted to be $425 billion. A: Sometimes it looks like consumer debt is rising because when interest rates are lowered, as they were at the end of 1991, home mortgages are refinanced or new ones are taken out and credit cards are used to-get-by rather than for consumption. Q: What's wrong with stimulating the economy by getting banks to lower their standards and make more loans during bad times? A: Any government stimulation would make consumers, bankers and the financial markets in general that much more on edge. Uncertainty is the enemy. It is natural to hang back and take a timid attitude when government intervention can strike and ruin plans without notice. Consider for instance what you would do if there was talk of reducing the tax on capital gains or instituting a nice credit for first time home buyers, or reinstituting the investment tax credit? You'd delay your plans in the hopes that by waiting for the legislation to be enacted you would save money. Government action or inaction skews decisions and puts a brake on the economy.

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Q: There's another side to this. A certain kind of government intervention can sometimes do a lot of good. I had a minority friend with a wife and three kids, who was a city employee with little debt, a steady income and equity in his home in a poor inner-city area. He searched high and low for a home-repair loan and finally found a mortgage lender to give him $35,000 at an outrageous interest ratethirty-four percent! When he couldn't pay the loan off at the end of two years he refinanced with other high-rate lenders and finally was evicted from his home of sixteen years by the third lender. A: That's a story that, I'm afraid, is repeated far too many times across the nation. However, the re-telling of unfortunate stories should do more than make us feel compassion; it should encourage us to find a solution. Q: I know the solution. This would never have happened if my friend had been able to find a decent bank loan in the first place. We should make banks become more even handed in their lending practices. A: Make? Through legislation, I suppose. Is this the good government intervention you had in mind? Bring in the power of the police state? Don't get me wrong. I certainly have sympathy with your friendin fact empathyI've been in similar situations. But what bothers me is the solution you derive from the incident. There is another lesson to learn. Q: What lesson? A: The need to assume responsibility. Your friend took on a risky loan and then when he was unable to perform he looked outside himself to place blame. Q: Let me tell you something. There have been studies that show that in a group of otherwise almost identical loan applicants, minorities were found to be turned down for mortgages between two and four times as often as the majority population. This despite civil rights laws and the CRACommunity Reinvestment Act. A: What do you know about the CRA? Q: Not much; only that it requires banks to meet the credit needs of low-income neighborhoods. A: I'd like to take a minute or so to tell you a little something about the well-meaning but ill-conceived CRA. The Community Reinvestment Act (CRA) was enacted in 1977, supposedly to encourage the banking industry to actively participate in economic development activities at the community level.

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Q: That's what I said. A: In effect it provided a legitimate avenue for blackmail. The CRA provides the umbrella under which groups protest the merger and expansion of financial institutions. The protests are generally designed, not so much to deny, but to delay the revenuegenerating endeavors of institutions. According to William Harvey, professor at Indianas University School of Law and former chairman of the Legal Service Corps board: Demands usually include an assorted menu of below-market interest-rate loans, specific geographical and dollar-amount lending targets, minority business loan emphasis, and outright cash grants to the protesting coalition. Such demands benefit specific interest groups, to the detriment of the community as a whole. Unfortunately the banking community has found it cheaper to give in to the protestors' demands than to fight them. Q: It seems to me that if victims kept caving in, it would encourage and increase extortion attempts. A: Exactly right. Federal Reserve Board statistics show the number of CRA protests filed in 1987 was more than ten times the number of all protests lodged in 1984. According to Professor Harvey, although the Legal Services Corp. is private it received more than $2.5 billion in direct Congressional appropriations during Ronald Reagan's presidency. The Professor claims the worst part of the situation is the fact that taxpayerfunded attorneys (funded by the Legal Services Corp. so ultimately by the taxpayers) not only represent protestors in many CRA cases, but often initiate the protests themselves and get paid. These protests often amount to nothing more than straight transfers of wealth from a productive sector to a non-productive set of individuals. Q: Assuming your information is correct, I admit it is possible that the activities of the CRA may bear some responsibility for the higher cost of banking which is one more economic hardship that the poor can ill afford. A: One more example of the law of unintended consequences. Q: And what would you do about redlining? A: Let's first define redlining. Q: Fine. What's your definition? A: Redlining is a pattern of discrimination in which financial institutions refuse to make mortgage loans, regardless of the condition of the property or credit of the loan applicant but simply because the property falls into an economically depressed neighborhood.

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Lenders used to outline these areas with a red pencil. Federal legislation was passed outlawing such practices. Q: I'd like to expand the definition to include discrimination on the basis of race, income and gender as well as location. As one of the provisions in the 1989 savings and loan bailout legislation, lenders were required to document, for the first time in 1990, the race, gender and income of mortgage-loan applicants. All earlier studies were lacking this information. A Federal Reserve study released in October, 1991 and showing a bias against minorities by lenders was based on this new information. A: I don't believe police power is the answer. Q: What is? A: Understanding and goodwill. Q: What have we got herea naive idealist? A: Fleet, the largest bank in New England recently stopped doing business with thirtyeight high-rate lenders and set up an eleven million dollar fund to refinance five hundred and fifity outrageous mortgages in the Boston area. Most of the mortgages were part of the portfolio taken over when Fleet absorbed the Bank of New England. Fleet is careful to evaluate the mortgage lenders with whom it does business. Although it looks for profitable companies it severs its relationship immediately with any company it determines is operating unethically Q: I don't suppose ethically means altruistically? A: I can tell you what John Strickland, president of the unit which purchases home-equity loans and second mortgage said on the subject, according to the Wall Street Journal on October 21, 1991.The higher the risk, the higher the rate. It's not illegal to make a profit. [But bankers] can't control what customers do with the money they borrow. Q: Customers. Meaning those high-rate second mortgage lenders? A: That's right. But when all the abuse and misery came to light, most banks admitted they were sloppy in looking only at mortgage yields and not checking into the real life situations that were represented by the paper. Q: You expect me to believe that bankers see their role as social worker commensurate with the business of banking? A: That is the difference between us. I have absolute faith in the innate goodness of most people, and believe it is both desirable and possible to solve most of society's ills by voluntary cooperation and with the police power of government only being called upon to correct or punish abuses. Ordinary people, through their innate goodness and creativity, I

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believe will come up with more and better solutions than all your stilted and one-kindfits-all pieces of legislation. Q: Oh Please! Tell it to the seventy-seven year old lady who had her home of thirty-nine years foreclosed upon because of a $5,000 twenty percent loan she took to cover medical expenses. A: You're bringing up the most outrageous and pathetic cases you can find as an emotional appeal. We can do this foreveryou blaming me for being naively optimistic about human nature and my accusing you of appealing to emotion in order to gain control over other people's lives. A: Let me make the first move towards getting this conversation back on a rational basis by suggesting that we agree that some banking practices need to be scrutinized by society and the banking industry. Q: Such as? A: The self-serving practice of the larger reputable banks of extending credit to highinterest lenders and then purchasing their notes on the secondary market. Q: In other words, like godfathers, they make collections through henchmen without getting their own hands dirty. A: Something like that. Many cut-throat mortgage lenders couldn't make it without backing from the reputable banks and access to the legitimate secondary mortgage market. The banks don't want to look beyond the high profit to the misery the transaction may encompass. Q: You are talking about passive neglect rather than active wrong doingright? A: Exactly. I believe if the men and women who run these larger institutions were enlightened, most would refuse to play, and even do as Fleet did; that is attempt to do something constructive about the problem. Q: I know you believe that people are like that, but I'm not so sure. A: I have a great deal of trouble with the rapid advance of lender liability law. Acts which are perfectly legal and common practice one day are illegal and a cause of action the next. Q: To tell you the truth, I've never even heard the term lender liability used as a field of law. When did this start? A: I guess you could trace the first lender liability case to 1982 when a California jury awarded $7.5 million to a borrower who suffered foreclosure by a bank on his delinquent

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loan. Then a couple years later a Texas jury awarded $18 million in damages to a clothing manufacturer who was able to show his firm was essentially destroyed by the takeover by incompetent bank managers. In State Nat. Bank v Farash Mfg. Co., the court ruled the lenders conduct was legal and had a legitimate business interest, but it failed to meet standards of fair play. Now you tell me whether or not that is ambiguous? Q: That's why we have juries and judges to rule on the ambiguities. A: Nevertheless the Texas Federal Appeals Court Justice decided social benefits derived from permitting the lenders' interference are clearly outweighed by the harm to be expected there-from. Consequently the lender was liable for damage and lost profits suffered because of the incompetent management the lender installed in a borrower's faltering firm. Q: What's the problem? A: I clearly have trouble with one-man's decision that the benefits to society outweigh private property rights and the discipline of a free market. Someone, albeit a judge. . . Q: Albeit a judge? Don't you agree that as members of a civilized society we must defer to a system of law which embodies judicial decisions? A: Of course. But I can and will criticize that decision. This judge has mandated that the collective good takes precedence over the rights of an individual and, in my mind, has set us back thousands of years. Q: I wish I'd brought my violin. A: This is no joking matter. Both judges and legislators are depriving citizens of the right to contract guaranteed in our Constitution. Lender liability is being found due to duress, bad faith breaches, fraud, fiduciary relationship and other theories. Liability that was nonexistent in many instances, less than ten years ago. Q: Duress has always been an affirmative defense. A: Fine; but now courts are ruling that when a borrower is faced with either financial ruin or taking the loan tendered, the bank may be guilty of duress. Forget all that went before in getting the borrower into such a condition. A borrower's mere fear of economic loss can make the lender liable if the borrower accepts a bank loan and later regrets his own decision. How can we live together and have business dealings when such absolute nonsense is given credencemore than thatsanctioned in our courts? In 1985 a grocery business in Tennessee was awarded $7.5 million by a jury who found the lender breached his obligation of good-faith performance and that same year thirtyseven million was awarded apple growers in California who were able to show that the calling of their loans forced them out of business.

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Q: Hold on there. I read about that apple grower case and an appeals court threw it out for insufficient evidence. A: True, but I was just documenting the expansion of this area of law and showing the mood, of juries, at least. After all have you ever met anyone who could not tell his own personal story of arrogance, insensitivity, incompetence or just plain negligence by a lending institution? Its little wonder juries are so willing to award large damages to borrowers. But this expansion of liability is as chilling to the banking industry as the expansion of product liability is to manufacturing. Anything that puts the brake on commerce and industry hurts our competitiveness in the world market. Q: Are you saying you would rather sacrifice the interests of individual borrowers for the good of the banking industry? A: I am saying that the interests are tied together. If banks are afraid to lend, borrowers suffer. I believe adequate avenues of redress are available to borrowers under existent theories of contract law without this expansion into a new field called "lender liability. Q: Well, you'll surely get an argument from the legal industry. Every expansion of liability makes more business for attorneys. Before they take any action business people are being advised to consult with specialists in environmental law, product liability law, civil rights law, employment law, and now lender liability law. A: Congressman John LaFalce introduced a bill in 1990 that would protect lenders from the large cleanup bills for chemically contaminated sites acquired through foreclosure. Gas stations, electric platters, metal finishers, wood product manufacturers and dry cleanersall users of hazardous materials in their processes, have found that banks are understandably reluctant to loan money to them or to consider their real estate as collateral. The Maryland Bank & Trust Co. foreclosed on a defaulted $335,000 loan and acquired 117 acres of land. After the foreclosure the EPA found drums of chemicals and contaminated soil on the site and cleaned up the mess, collecting $500,000 from the bank that had nothing whatsoever to do with creating the problem. An Indiana bank told a congressional committee that recent court decisions on environmental liability could prevent it from financing that community's only auto body shop, its only gas station, its only fuel dealer and much of the area's farm land. A Massachusetts chemical company had to pay $20,000 for soil testing and legal fees before a bank the company had used for twenty years would give it a loan. Q: I've got a story or two of my own. John Shontz, attorney for the tiny Miner's Bank of Butte, Montana, in testimony before a congressional committee in the fall of 1990, asked if legislators were anxious to make small banks insolvent and reminded them constituent tax-payers would end up with the tab. He referred to the situation where government was

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holding the Miner's Bank partly responsible for the $10 million cleanup of a site which it owned for only three months after it foreclosed on a failed business which had chemically treated and preserved wooden telephone poles. The Montana bank only had working capital of $2.5 million and this government imposed liability would no doubt sink it. A: In May, 1990 the 11th Circuit Court of Appeals held a lender liable because the bank could have influenced a company's waste disposal decisions if it had chosen to do so. Q: Could have but didn't? That's stretching! I know you think there should be limits on liability. A: Environmentalists oppose efforts to limit the liability of lenders. Q: What do you think about the recent proposal made by James Strock, an officer of the Environmental Protection Agency? He claimed a new rule should require that they [lenders] try to determine whether real estate accepted as collateral contains hazardous waste. A: Requiring lenders to determine the potential environmental liability on property before making a loan will impose one more burden on the already heavily burdened business sector. It will slow up the economy in terms of time and money as inspection services emerge to exact another toll on our overregulated society and price of real estate. Q: Well, Mr. Strock thinks the LaFalce bill offers blanket immunity to lenders. A: The potential cost of cleaning up hazardous waste in the U.S. could run up to five hundred billion over the next fifty years and as things stand, banks could be liable for at least twenty percent of the cost. Q: That's some potential liability! A: Equally disturbing is the inability of parties to make binding contracts in this day and age. Q: What do you mean by the inability to make contracts? A: The UCCUniform Commercial Code, as you probably know, is law adopted by states to give some uniformity to commercial transactions throughout the nation. Under its code there is a covenant of good faith and fair dealing in commercial transactions and a recognized tortbad faith breach. Q: In thought that in California the tort is independent of the UCC. A: Exactly. Anyway banks must treat their customers fair and reasonably no matter if the signed written documents between the parties say otherwise. This determination of fairness is, by law, to be left to third party judges or juries and can not be settled by the

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contracting parties. This leaves the parties with a potential liability over their heads and is definitely an unhealthy climate for business. Q: Are you serious? Having a stipulation that parties deal fairly with one another is bad for business? A: Fairness is one of those illusory concepts, like beauty, and is often in the subjective eyes of the beholder. What is fair at one moment in history may not be in another. Those best able to determine what is fair in any given situation are the parties to the contract. Would you be as likely to enter a contract if you knew someone could not only wriggle out of it later but also obtain punitive damages against you? I'd find another business, or charge every customer enough to make it lucrative enough for me to cover the possibility of being sued. Q: That's not good for anybody. A: You're getting my point. Banks have been found guilty of breaching the covenant of food faith and fair dealing when they stop advancing funds or switch formulas for advances under an established line of credit. Q: Even if they are given the right to do those things in the written agreement signed by the customers? A: Even then. But don't get me wrong. I'm not against holding a lender liable where, for instance, a loan office cuts a customer off out of a personal vendetta or fails to stick by the reasonable notice provisions in agreements. Q: Even if the insufficient time is what has been previously agreed to in the written document? A: That's something different. I realize the unequal power of the parties has long been considered in courts of law, but I am still unhappy with the rewriting of a legal document. The only reason one would sign a subjectively speaking unreasonable document is to better his or her situation. Only the signer can determine the reasonableness of any action in the light of the choices he or she is facing at the time. Q: Nonsense! Many people who get roped into unconscionable one-sided contracts don't read the documentation or if they do they don't really understand it. A: You want to think of them as children and remove all responsibility for their own welfare from them. I believe you are well intention but dead wrong to encourage people to throw themselves on the mercy of others. If you go on the premise that the majority of people are basically good and want to help one another than you will not scoff at the idea that even an illegal immigrant who doesn't speak the language in which the contract is written, can go to a priest or friend of a friend for help.

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Q: I can't believe you! He or she doesn't, or in all probability wouldn't, because of fear. A: That is a trade off. Not facing up to their fear may subject them to a one-sided loan. Easy prey. I realize that just as there is a majority of good eager-to-help people in any community, there are also the sharks and scavengers with no qualms about taking advantage of the weakness in others. Q: I'll give you that. No matter your weakness there is always someone hanging around to exploit it. It could be the drug dealer, liquor salesman, race track or even the state lottery. I suppose you would put the government in the category of a shark in promoting gambling, which is so often the weakness of those who can least afford it. A: That is a subject too far afield for our present discussion, but I will say in passing, that lotteries are not per se good or evil in my mind. I can see that a person is purchasing hope, excitement and in many cases is contributing to worthwhile public endeavors. Nevertheless, I do not favor them because of the temptation they present to some players. Q: Getting back to the loan documents; the covenant of good faith and fair dealing requires a bank to be reasonable in dealing with a borrower. Right? A: You're getting us right back to where we started. Reasonable is just as ambiguous as fair and is best determined by contracting parties. Q: Equal contracting parties. A: There you go. And you wonder why institutions hesitate to lend to anyone but sophisticated borrowers who don't really need the money. Don't you see what all the good intentions are doing to the people they purport to help? Q: I don't suppose you have any trouble with holding banks and other lending institutions liable when it comes to old fashioned fraud; suppressing facts which should have been disclosed, making misrepresentations to the borrower or third parties, making promises with no intention of keeping them and so forth? A: Fraud doesn't interfere with the parties ability to contract. Q: What about finding liability via the fiduciary relationshipthe duty the professional lender owes to the borrower through their special relationship? A: A fiduciary relationship is a special relationship where the advising party must place the advisee's interests above his own and is not normally found in a lending situation. Q: It was found to be at least a quasi-fiduciary relationship in 1985 in California. The lender must do nothing which could hurt the borrower's interests. Liability has also been established in California where excessive control by the lending institution over the borrower can be shown. Also a joint venture can be found if an institution becomes too

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involved in a borrower's business and liability has been established for breach of an implied joint venture agreement. I read in the October, 1986 issue of Case & Comment : Banks should get competent legal advice before taking any enforcement action. Any arguably questionable practice should be approved in advance by an attorney who is well-versed in the area of lender liability. A: The RTC and FDIC spent close to $900 million on legal services in 1991 with about $700 million going to private law firms. That's a hefty price even for competent service, but Richard Schmitt, reporter for the Wall Street Journal told of hiring a private firm that not only appealed the wrong case, it filed its appeal the day after the filing deadline expired. It was a $1.2 million mistake, but was easily absorbed in the budgetary item labeled waste and passed on to patient, accepting tax payers. Q: Isn't anything being done to minimize legal costs? A: The FDIC beefed up the auditing section which kept an eye on the 1,600 or so law firms that were expected to receive fees from the FDIC and RTC in 1991. Auditors found overstaffing, unauthorized research and inflated clerical expenses and are getting law firms to make refunds of an average three percent of fees previously paid. Q: Physicians have endured this type of oversight for years. A: The ABA Journal [November 1991] listed twenty law firms whose 1990 receipts from the FDIC topped $2.5 million. Fees up to $600 an hour had been authorized. Henry Gonzalez, chairman of the House Banking Committee found the fees of outside law firms often excessive. Hokpins & Sutter of Chicago headed the list with receipts totaling $22.3 million. In February 1991 a cap of $2.5 million was put on the fees that the FDIC or RTC can award any single law firm in any one year. Q: It seems like this would spread the agency business around, if nothing else. A: In 1990, regulators, on the advice of outside counsel given by a private San Francisco law firm and paid for by taxpayers, turned down a seventy-eight million settlement and won a sixty-eight million suit. Q: It wouldn't be so bad if taxpayers got their money's worth, but a loss of ten million dollars! A: In that particular case the federal judge had warned that for the FDIC to go to trial would be playing Russian roulette with taxpayer dollars. Despite these incidents, the FDIC maintains that it gets back an average of twenty-nine dollars in recoveries for every dollar spent.

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Q: That figure has been disputed, but let's leave it at that. Have you heard of something called FASB and if so what is it? A: FASB is an acronym for the Financial Accounting Standards Board which is the chief rule-making body for accountants. FASB has a proposal requiring footnote disclosure in all financial statements of more-current values of assets and wants banks to hold larger reserves for bad loans, beginning sometime in 1992. These two items will be costly for banks. Just to estimate the fair value of loans will be demanding. Q: So what's the point? A: It is supposed to give analysts a clearer idea of a bank's soundness. Q: How are loans booked now? A: By book value. There was an earlier call for market-value accounting which has been watered down somewhat to this fair value proposal. Q: What is fair value? A: Fair value is the current market value and it will be required as a foot note to financial statements for all financial instruments including equity, debt, loans, receivables and even options. Banks with less than $150 million in assets will have until 1995 to adhere to the new accounting disclosures. FASB also has a proposal for troubled loans effective for calendar 1993 requiring banks to include interest components in their calculations of reserves for troubled loans. This would increase the carrying costs for troubled loans on the balance sheet and could sharply reduce reported profits. Q: It sounds like this would hurt the banks. What is the justification for such a proposal? A: For one thing it could encourage a faster dumping of bad loans. Q: It seems to me if banks have to factor in carrying costs they will have less incentive to hold delinquent loans and struggling borrowers will be given less of a chance to revive something I believe is an unfortunate consequence. A: Philosopher Kings think this is all for the good as banks will be able to put their mistakes behind them quickly rather than try and help a struggling entrepreneur weather bad times. Q: Such a prompt disposal policy could intensify current real estate problems by encouraging more and faster sales of construction loans and mortgages when the market is already saturated.

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A: Well the Bush administration has tried to encourage bankers to work out and resolve problem loans rather than foreclose, if it all possible. Q: Didn't you say earlier that the banking problem in 1991 is not restricted to this country? I just wonder what kinds of problems some of the other countries are facing and how they are dealing with them. A: Japan still has eight of the ten largest banks in the world but they are being restricted by nonperforming loans and rising costs. German and Swiss banks are more profitable. Japanese banks had non-performing loans equivalent to almost thirty and a half billion dollars [3.9 trillion yen] at the end of 1991. Q: I heard the face value of those loans was worth more than five times that amount. A: You're right. Because of lax financial-disclosure requirements, it's hard to get accurate figures. Management by bank regulators doesn't seem to be any better in Japan than in the U. S. In 1986 eleven Japanese banks had top credit ratings but by the end of 1991 none did. Many of the larger Japanese banks were being pressured to absorb failing smaller banks. Q: That sounds like a repeat of what happened in the 1930s. There were seven hundred Japanese banks in 1931 and ten years later that number had dropped to one hundred ninety. A: You should know the deposit insurance system in Japan is not funded according to our American standards. Premiums paid by participating lenders could barely cover a handful of very small institutions. The banks keep small reserves because they have to pay taxes on reserves that exceed three tenths of a percent of total loans. Q: I know. They also pay taxes on bad loans which the government makes them keep on the books for a full year after borrowers have stopped paying interest. A: Japanese manufacturers depended on bank loans for their rapid expansion. When their profits began to decline in the nineties, as the result of the recession in that country, Japanese banks took the hit. Q: Not that long ago, [1989] the largest Japanese manufacturers had accumulated cash amounting to four times their annual expenditure on plant and equipment. Loans were not needed. A: They weren't needed because the Bank of Japan adopted a loose monetary policy and cheap capital meant businesses could raise money through the stock and capital markets and by-pass the banks altogether. Q: But weren't the banks speculating in stocks, securities, art and the already inflated real estate market?

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A: That's right. Between 1985 and 1990 real estate lending tripled. Our own government pressured the Japanese Finance Ministry to lift controls on the rates paid to Japanese depositors. Q: What do they say about misery loving company? A: Well misery got its company in this instance. The same thing happened there as here. Depositors were paid more but it took awhile before lenders could be charged more for the use of those funds. The spread between the cost to the banks and the yield, widened. Q: But I guess the risk was masked by the hot speculative market. A: Then just at the very end of 1989, Uahushi Mieno, Japan's counterpart to our Alan Greenspan, raised the central bank's discount rate. It fluctuated but two years later it was still double the old 1989 rate of two and a half percent which had provided such a joy ride for investors. Q: I know that caused problems, but what kinds of problems? A: For one thing, it depressed stock prices, making it harder for the banks to raise capital. In addition, many of the banks' customers and their own investments were hurt, just as banks' costs rose. Then to top it off, the Bank for International Settlements imposed stricter capital ratios. Q: Could you backtrack and go into the Basle Accords a little bit? A: In 1988 the Basle Accords were agreed to by the central banks of the leading industrial countries. All the world's bank regulators, Americans included, promised to compel the banks they supervise to keep capital at a prescribed percentage of assets. The idea behind the uniform standards was to prevent banks in one country from having an advantage over banks in another country. The Basle requirements meant stricter capital ratios and signaled the need for banks to raise new capital to grow or even to keep from shrinking in some cases. Q: What exactly do you mean when you use the term capital here? A: Capital is the difference between the market price of a bank's assets and market price of its liabilities. Q: What are the uniform ratios required by the Basle agreement? A: There is a rather complicated formula involved but the bottom line is that by the end of 1992 banks will have to have capital equal to eight percent of their assets. It changes how banks value assets.

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In the past, regulators in this country have permitted banks to value equity, another word for assets, at the original cost rather than the current price so they don't have to write down real estate loans during depressed times. They figured that banks intended to hold onto devalued properties until the market turned and so there would be no actual loss until a property is sold, or in some other way, transferred. Q: We just got through agreeing that old practice was a good idea. A: But the new rules spell trouble and not only for American banks. Midland Bank, once Britain's largest, replaced its CEO and cut its dividend in the spring of 1991 and Moody's dropped the ratings on the huge Japanese banks, leaving only one with a AAA rating. Q: Actually these capital requirements may be less arduous for American banks than for banks in other countries. A: Why do you say that? Q: According to financial analyst William Ferguson, already 9,500 of this country's 12,000 banks [two trillion in deposits] have assets of a hundred million or less with capital of eight to nine percent. Anything above four percent used to be considered respectable. A: That's true. Besides, equity accounts for about five percent of all funding sources for American banks and savings and loans; fifteen percent for consumer finance companies and seventy percent for non-financial companies. Bankers have argued for the inclusion of subordinated debt as well as equity in the regulatory definition of capital. Regulators tend to look at capital as a buffer to absorb credit losses, whereas banks view capital as an expensive source of funds. Q: In this country, bankers figure that in order to cover reserves, deposit insurance, and other requirements, they now have to build about one and a quarter percentage points into the rates they charge customers on their loans. A: Foreign and nonbank competitors have been spared these costs. Q: According to the New York Federal Reserve Bank, just a few years ago large U.S. corporate customers were borrowing four dollars from foreign banks for every ten dollars they got from major U.S. banks. A: I think you will find borrowing from the foreign banks has increased. Former Federal Reserve Chairman, Paul Volcker, Douglas Barnard of the House Banking Committee and Senate Banking Committee Chairman, William Proxmire all agreed in 1987 that we needed to allow U.S. commercial banks to compete or we were going to lose our market place to the Japanese and Europeans. Ralph Ziegler, Vice President of the Union Bank of Switzerland in Tokyo, was quoted as saying:

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Japanese banks have a market-share-driven strategy world-wide, and it works. I have absolutely no doubt that in the battle for global supremacy the Japanese are going to make it. Q: Japanese banks have picked up a large market share in this country where low interest rates are more important than innovation. A: This is especially true in the state and local government market where Japanese banks sell letters of credit which enhance the credit rating of the municipality or agency wishing to float bonds or notes. The more a bank is able to increase the issuer's credit, the less the issuer has to pay to borrow money. Q: And Japanese banks can offer high credit ratings because the Japanese government can be counted on to bail them out. We hear so much about American loans to Latin American countries but the Japanese got burnt in the same marketforty billion to our hundred billionand are therefore leery of risky or relatively unknown borrowers. Lending their credit ratings to American state and local governments is a low-risk business where the default rate is far lower than for commercial loans. A: Tell me about it! The state of Michigan was saved from a budget crisis in 1982 when the Mitsubishi Bank agreed to guarantee five hundred million worth of the states bonds. In 1986 the Bank of Tokyo lent five million to a group of New York developers who were building an office complex in a run-down section of the Bronx. The city of Boston, also in 1986, solicited competitive bids on a hundred million dollar note. The three lowest bids were Japanese with the best U.S. bid twice as expensive as Sanwa, the winning Japanese bidder. City officials estimate Sanwas bid saved the Boston taxpayers somewhere between $130,000 to $400,000 in fees. And Bostons experience was not unique. In December 1986 the Arkansas Development Finance Authority found its three best bids were Japanese and that the winning bid from Sumitomo Bank saved it just under two million in reduced interest costs and other fees over a three year period. Q: I've heard the Japanese sacrifice profit for market share. Sometimes they earn less than one-tenth of a percentage point for supplying credit, less than half what an American bank might consider to be profitable. A: I've heard that too. Apparently even the most westernized Japanese bankers disdain U.S. and European notions of what constitutes an acceptable profit. Some Japanese companies are able and willing to forebear profits for up to ten years in order to build up business.

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Q: This used to be pretty standard operating procedure for any new business in this country also. However, most of our banks are not new to the market and are being forced to compete with these foreigners who are willing to lend on much more favorable terms. A: There's truth to what you say. Some Japanese banks offer loans to U.S. businesses at between 1/8 percent and 1/4 percent below the savings rate at American Banks. Q: A deal too good to turn down! Consequently, by the end of 1986 Japanese banks held eight and four tenths percent of all commercial loans in this country. A: Actually the Japanese economy as a whole is a low-profit operation. Sumitomo Bank returns a mere thirty cents on each hundred dollars of assets whereas Citicorp returns seventy-five percent. Q: Japan may be the place to borrow but not to invest. A: We're agreed then that American banks are more profitable, measured by return on assets, than are Japanese banks. And amazingly, the ten most profitable banks in the USA are community banks with assets of thirty-five million or less. Q: I've always wondered why the Japanese people save so much, especially as restrictive regulations are responsible for the rock-bottom interest rates the Japanese pay their own citizens on savings accounts. A: You would hardly think this would be an inducement for the Japanese to save, but for them there is little alternative. For instance a few years ago buying a hundred shares of a fifty dollar stock cost a Japanese investor as much as sixty-three dollars in fees. Between their commercial banks low government-controlled rates of interest and the high fixed commissions charged by the securities firms, there is little choice. On the other hand, you have probably heard more than you care to about the deplorable savings rate in this country and the disincentives to save built into our tax code and social policies. Q: As far as I'm concerned, saving is for American suckers. For instance those prudent enough to have saved, rather than practice the enjoy-as-you-go philosophy, are the ones that end up in an income bracket guaranteed to force them to pay even more taxes on their already taxed Social Security benefits. A: You may be right there. Savers are rarely rewarded in this country, but end up footing the bill for the non-savers, who may or may not have been profligate spenders in their youth. When will our policy-makers understand that we get what we encourage? In the future were going to get non-savers. Q: But in contrast to the message delivered in our social and tax policies, the government urges the purchase of savings bonds. Employees of many companies purchase savings

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bonds through automatic payroll deductions. This program raised five billion in 1985, enough to cover about two and a half percent of new government debt. But savings bonds have to be held at least five years to avoid ending up with a return as small as four percent. A: Still twice the best return many young people are expected to get from their Social Security contributions. Q: If held ten years to maturity the savings bond rate is higher, even though I admit it varies, and may be a viable vehicle for conservative investors. A: Especially when you consider the tax on the interest is deferred until the bonds are redeemed. U.S. EE savings bonds had a minimum seven and a half percent guaranteed interest rate for quite some time. That was cut near the end of 1986 in order to save the government money and to reduce competition with private offerings. In the first half of 1988 a saver could receive eight percent on a five year Treasury and a thirty year zero coupon Treasury (non-callable) was paying nine percent. Q: Ah, those were heady days! At an interest rate of nine percent, savings double every eight years. A: Absolutely right. I think if we made sure our youngsters understood these things in school we'd have a better chance of increasing our savings rate in this country. Q: In 1983 foreigners added seventeen billion worth of U.S. Treasuries to their holdings. A: In 1985 the Japanese increased their holdings of U.S. Treasury bonds by nineteen billion, triple the previous years rise. At year-end 1985, the Japanese held forty-seven billion of the U.S. governments two trillion dollars debt. That was up from twenty-seven billion a year earlier. At U.S. Treasury bond auctions in the eighties, the Japanese have been known to gobble sixty percent of a new offering. Q: The Japanese and West Germans bought the Feds newly created dollars in order to protect their export industries and to ensure the value of their own dollar holdings. A: What few people realize is that until 1986, Japans foreign financial investments were limited almost exclusively to the purchase of Eurobonds and U.S. Treasury issues which offered a secure return of eight or nine percent. Q: And that was a full four percent higher than the yield on comparable Japanese bonds. A: Right again. However, in the summer of 1986, the yield on long-term Treasuries, at about 7.1 percent, was low for the Japanese. They had been used to investing in U.S. securities only when the yield was at least three hundred basis pointsthats three percentage pointsabove Japanese government bonds, which were then yielding about

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4.5 percent. Nevertheless that year Japanese banks purchased about a quarter of all U.S. Treasury bonds. Q: In effect funding our deficit. A: Exactly. However, as our interest rates began to fall and our dollar continued its precipitous slide, the Japanese suddenly began losing their appetites for our Treasury bills and started buying up prime U.S. real estate and other equities. In the first quarter of 1987 the Japanese took advantage of the forty-five percent drop in the dollar relative to the yen [from its 1985 high] and began buying our blue chip stocks at a rapid clip. Our stock market was too good to pass up, with American stocks offering higher yields than the Japanese home markets [seven percent vs. little more than half of one percent] and much lower price-earnings ratios [16 vs. 49]. Before the October, 1987 stock market plunge, many Japanese brokers had estimated that by 1991 Japans total holdings of U.S. equities would reach a hundred billion or about four percent of all U.S. equities. Q: That didn't happen. A: Let me tell you what is happening in Japan. Not long ago Japans seven trust banks and twenty-one life insurance companies were the only entities authorized to manage tax-exempt pension funds in Japan. Japans pool of retirement savings amounts to over fifty billion and is expected to skyrocket in the next decade as the aging workforce sets aside more and more for their retirement years. The average Japanese retires at age fifty-five, earlier than in the United States, and can expect to live longer. Today [1991] one in eight Japanese is sixty-five or older and by the year 2005 Japan will be the nation with the largest percentage of its population over age sixty-five. With a greater need for retirement income and the poor returns that have thus far been produced by their own Japanese trust banks, there is a blossoming interest on both sides for American access to those pension funds. Q: We are seldom told that the need has been on both sides; the need for the U.S. to borrow and Japan to lend; or should I say invest? A: In the eighties the coffers of Japanese banks became so over laden, thanks to Japans huge trade surplus, that the Japanese had no way to invest all that money domestically. In 1987 Japanese banks, insurance companies and brokerage houses were flush with more than five hundred billion for investment in foreign countries. Q: Wasnt that because at the end of 1986 the Japanese Finance Ministry liberalized capital flows from Japan?

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A: Youre right. The Japanese Postal Insurance Fund, which is managed by the Post and Telecommunications Ministry, used to be allowed to invest a maximum of ten percent in foreign bonds. The ministry doubled the amount allowable and also made it possible to invest in foreign corporate bonds. Formerly investments were allowed only in bonds issued by foreign governments and public organizations. Q: I understand that Japanese commercial banks are very closely regulated. So how do they decide how much interest to pay depositors or charge lenders? A: As far as the interest rate on bank deposits goes, sixty percent is set by regulation and the other forty percent is determined by the marketplace. Certificates of deposit and although foreign deposits escape rate regulation, the number and size of those deposits is strictly limited. Q: I've heard the term national treatment. Just what does that mean? A: Most of the world adheres to a principle called national treatment which means that foreign firms must have the same rights given domestic firms. Japan doesn't abide by it. On the level-playing-field principle, the Fair Trade in Financial Services Act of 1990, backed by Senator Don Riegle and at least ten other senators, would allow U. S. regulators to limit Japanese bank expansion in this country. Q: If the idea is to get fair treatment for American firms from the countries whose firms we treat fairly here, it's an idea whose time has come. American businessmen can forget about being successful abroad without the presence and help of American banks in foreign countries. A: The United States dominated worldwide banking in the 1950s and 1960s but the European and Japanese banks got a real foothold in this country during the 1970s. Q: Wasn't anything done to preserve our market share? A: The International Banking Act of 1978 was passed in response to complaints that the operations of American banks were restricted when compared to the unchecked operations of foreign banks here. That proverbial level-playing-field was the goal. Q: What did the Act contain? A: The legislation required foreign banks to submit to our federal bank examiners, carry insurance, maintain reserves, adhere to limits on interstate banking and non-banking activities and be licensed. However, it grandfathered in a couple competitive advantages like letting foreign banks continue underwriting securities Q: Even though Glass-Steagall prevents American banks from doing the same?

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A: Unfortunately, yes. It also granted national treatment to foreign banks even though no other country gave us national treatment in return. Q: Our lawmakers call that a level playing field? A: In 1987 the Senate passed a bill denying the application of any foreign bank whose country does not grant American banks national treatment. Q: I thought you said. . . A: Hold onthe House failed to pass the bill. Q: Terrific! So Japans banks overtook their American counterparts as the worlds largest international lenders. A: The Japanese have established banks in Australia and London where some thirty-five Japanese banks account for twenty percent of all British banking assets. The United States is now host to more than thirty-eight Japanese banks, Q: Including the five largest banks in California. A: In February 1988, J. P. Morgan Co., the last of the American companies to enjoy a triple A rating, lost it. About the same time Federal Reserve Board Governor. Martha Seger, appeared on C-SPAN. Martha Seger disavowed any protectionist sentiments but expressed anger because of the unlevel playing field on which American banks were forced to compete. She declared that the Bank Holding Company Act, which controls how foreign banks operate in the United States, should be scrutinized. She was not shy in pointing out that in Japan U.S. banks are not treated on a par with Japanese banks whereas Japanese banks are treated even better than U.S. banks when they come to this country. Q: Good for her! A: You know, after the Second World War Japan had a very tightly regulated financial system. In an attempt to prevent the concentration of capital in the hands of a few institutions, the Japanese put into their banking law a word for word translation of the American Glass-Steagall Act. Q: Our law which prohibits banks from underwriting corporate securities? A: That's it. But the Japanese didn't mimic all American banking regulations. Q: For instance?

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A: The Japanese have lower capital requirements than do American banks. When the Federal Reserve Board required U.S. banks to set aside cash, bonds and other lowyielding capital, equivalent to five and a half percent of their assets, Japanese banks kept about half as much in capital. That one change meant they could lend more cheaply. Q: But we didn't always have such stringent capital reserve requirements in this country. A: You're right. Between 1933-1947 debt to equity ratios soared in the United States but dropped under the pressure of capital regulation in the 1950s. The ratios climbed again as deposit protection expanded. Q: Of course now the Basle Accords instituted in 1988 have made this ratio of capital to assets uniform worldwide and set at eight percent. [Basle II revisions were published in 2004 with full implementation anticipated by 1915. However the 2009 global financial problems has triggered more discussions, referred to by some as Basle III. This issue is worth a Google search or at least a reading on Wikipedia.] A: Even earlier, in December, 1987 the Cook Committee for Bank International Settlements announced standardized capital guidelines for banks operating in eleven or twelve countries. The fear has always been that higher capital requirements may cause banks to invest in riskier assets in an attempt to maintain a given rate of return on equity. But according to bank analysts Michael Keely and Frederick Furlong The value of the deposit insurance guarantee to the bank rises as asset risk increases. Increasing leverage by increasing deposits relative to initial assets also increases the value of the deposit insurance guarantee. Q: I take that to mean that a bank, if allowed, can increase the wealth of stockholders by either increasing leverage or asset risk. A: According to Keely and Furlong, as the capital of an insured bank increases, the banks incentive to increase asset risk falls. Therefore banks with the lowest capital ratios have the greatest incentive to assume risky asset portfolios. More stringent capital requirements would not give banks more of a reason to invest in riskier assets; it would give them less of an incentive to do so. Q: Yes, but insured depositors are naturally not concerned with bank risk-taking and are willing to lend to banks at a risk-free rate since their deposits are insured. A: Exactly. And this provides banks with an incentive to increase asset risk or leverage, leaving the deposit insurance fund with unconscionable liability to taxpayers. Specifying different levels of capital requirements for different risk assets and off-balance sheet commitments, would introduce a new dimension to decisions about loans.

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Q: Isn't it true that under the new guidelines banks wont be able to securitize many types of loans because they will have to supply more capital than required by their actual exposure to loss? A: Because regulators have recently forced commercial banks to increase their ratio of equity capital to loans [debt], banks have a strong motive for trying to beef up earnings without expanding their loan portfolios. Only a few years ago hocking portions of a bank portfolio was unthinkable. But it makes a lot of sense now when banks want to get loans off their books. Q: Actually I'm not really sure what is meant by the term securitization. A: Securitization is the packaging of loans for sale to investors. First mortgages now account for three hundred billion-plus with securitized auto loans making up another ten billion dollars annually. Other consumer loans are being considered for securitization; boat loans, mobile-home loans, home-equity loans, second mortgages, credit-card loans and even non-performing loans are all examples. The trouble is the best loans are the most marketable and banks are often left with the most risky loans in their portfolios. Q: I guess securitization has caught on because there is something in it for everybody. A: Bank regulators were skeptical in the beginning, but in 1986 ruled that banks can eliminate the loans through a securities sale as long as the buyers are not given recourse to the bank that first made the loans. [Something that contributed greatly to the 2009 debacle.] Issuers get a financing source which allows them to take the assets off their balance sheet and thereby increase the return-on-asset and capital-to-asset ratios. Investors get a higher yield than they could get with comparable securities. Consumers, because securitization provides greater pools of money for lending, should reap the benefits of lower interest rates on consumer loans. Q: At the beginning of March 1987, Bank of America announced a four hundred million public offering of securities backed by credit-card loans. In this instance investors will receive the cash flows from repayments but must absorb any losses if the default rate on credit-card loans runs unexpectedly high. Account holders should not detect any difference because the bank will continue to service the credit-card accounts the same as always. A: The sale of these loans give banks additional room under regulatory capital-to-loan guidelines to make new loans. Q: This may sound stupid, but I'm serious. Why do we need banks? We can get cash through automated teller machines set up by companies like Sears, AT&T and American Express. To put our money into savings and checking accounts for safety and convenience we can use mutual funds.

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We don't even need banks for loans. Auto companies finance car loans, mortgage bankers finance homes and entities like GE Capital and insurance companies lend to businesses. Big borrowers can often borrow more cheaply in the public debt markets than the bankers can. A: In his 1991 book, The Future of Banking, University of California-Berkeley Professor of Economics, James Pierce, agrees that there is nothing especially unique about banking anymore. At the end of 1990 banks held only sixteen percent of the three trillion in residential mortgages and less than fifty percent of all auto loans. Prudential Securities has an insured income account which includes checking privileges covered by the FDIC $100,000 guarantee. The business community can raise short term cash by selling commercial paper or for long-term money they can issue bonds. As you said, small and medium sized companies can turn to General Electric, General Motors and Ford who all offer business loans to consumers. Q: You realize that because investments were restricted at home, Japanese investors were induced to make large scale overseas investments. Now it is up to policymakers in this country to loosen the restrictions they have placed on American financial institutions and to allow them to compete on that mythical level playing field. [This was one reason for the deregulation that is being blamed for the 2009 financial chaos.] A: I agree. In an unregulated market place borrowers and lenders are free to make their own decisions and disinterested taxpayers are not made to pay for the mistakes of the parties to the transactions. Q: We've been dwelling largely on Japan. What about Europe? A: A lot of exciting things are going on there. In 1990, months before full reunification, state property in East Germany. . . Q: Then you must mean all property in East Germany. A: Anyway government property was turned over to an agency called Treuhandanstalt (Trustee Institute) known as THA. In April, 1991, under the dynamic leadership of Birgit Breuel, once the finance minister in Lower Saxony, THA began to sell the property. In less than six months it had sold 3,788 businesses. Q: That must have produced a lot of revenue. A: Only eight billion but you can imagine the run-down condition of the communist managed properties and it is a wonder that there were any bidders. On the bright side, the purchasers promised to invest fifty billion to restore the properties. Q: Which I would imagine would create a goodly number of jobs.

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A: Seventy-two hundred new jobs. Q: I don't suppose I'm alone in my suspicions but to tell you the truth the thought of that many properties being sold at such low prices makes me think of government favoritism. A: You're right; you're not alone in your suspicions. And the fact that many German citizens were claiming the government failed to get high enough prices and that buyers might not fulfill their investment commitments and so forth, only increased my admiration for the woman who was brave enough to go ahead and do what had to be done despite suspicions and criticism. Q: One can hardly help but compare Germany's THA with our RTC (Resolution Trust Corp.). A: Now you've got it! East Germany, of all places, is actually privatizing while our own congressmen and women ho and hem in an attempt to curry favor with their constituents. Q: I can understand how many of the cumbersome restrictions imposed on the RTC were attempts to appease both the banking and real estate industries. Is that what you are getting at? A: There's more to it than that. In formulating the rules by which the RTC, as landlord of confiscated property, was to offer it for sale, an effort was made to cater to many special interest groups. Before soliciting buyers in the regular marketplace, first right of refusal sometimes has to be tendered to representatives for low income-earners in need of affordable housing, minority groups, homeless advocates and even government agencies who might make use of habitable buildings. If you know anything about me you know how I hate the many trite comparisons of the United States with other countries. This case is an exception. The THA is selling off miserable assets at a business-like clip, partly because it has its management staff on a strict budget of twenty-two billion a year. In this country we fund everything according to need or desires. If the job takes more than the money authorized, the RTC, or any and every other agency, simply asks for more money. No discipline, no budget, no limits. Q: And the worst thing about the way we have been doing business in the United States over the past couple decades is that our leaders don't bother to ask their constituents for the extra funds, they just put it on the tab to be paid by future generations. A: I'm mad as all get out and I for one am not going to take it any more. I put a lot of time and effort into raising five members of this future generation and that's why I'm determined to do my darndest to turn things around in this country.

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