In the view of Representative Bill Posey of Florida and some colleagues on the House Financial Services Committee, bank examiners are clamping down on otherwise perfectly healthy banks – and forcing them, inappropriately, to classify some loans as “non-accrual” (meaning less likely to be paid back).
Mr. Posey has therefore introduced a bill that would direct examiners to regard all loans as “accrual,” as long as payments are still being made – and a hearing was held on July 8 to discuss the merits of the matter.
Perspectives from expert contributors.
I testified at the hearing and was not supportive of the bill. On the subsequent panel of witnesses, representatives of theFederal Deposit Insurance Corporation and the Office of the Comptroller of the Currency, the relevant regulators, testified even more forcefully against the proposal.
George French, on behalf of the F.D.I.C., said in written testimony, “This proposed legislation would result in an understatement of problem loans on banks’ balance sheets and an overstatement of regulatory capital.”
The big issue is “regulatory forbearance” – whether regulators should look the other way when banks get into trouble, allowing them to be nicer to their borrowers and, in the optimists’ view, manage their way to recovery.
The problem with such forbearance is that it has a long history of leading to much bigger problems. The savings and loan crisis of the late 1980s and early 1990s began as a relatively small problem at some Texas mortgage lenders.
Congress responded to the complaints of these institutions, which asserted that they had been poorly treated by various changes in rules, and the result was legislation that gave these savings and loans enough additional rope (and forbearance) to hang themselves.
In the end, a significant number of people went to jail and taxpayers had to pay nearly $150 billion to clean up the mess. (Recommended summer reading for all members of Congress and everyone else: “The Best Way to Rob a Bank Is to Own One: How Corporate Executives and Politicians Looted the S&L Industry,” by William K. Black.)
The core problem today is that while community banks were not the main driving force behind the financial boom and bust, in some states they made some very bad decisions. Among the members of Congress who spoke on Friday, I heard strong voices from Florida, as well as from New Mexico and Georgia. In all of these places, thinly capitalized community banks made very bad bets on real estate, often commercial real estate.
The regulators made it very clear in their testimony that the rules have not changed, and they continue to apply the same accounting principles as before. The principles are straightforward and reasonable: a loan cannot be classified as accrual if you do not expect it to be repaid in full.
Allowing banks to classify failing loans as accrual will overstate their financial results and make it look as though they have more capital — that is, greater shareholder equity — than they do. The problem is that some community banks do not have big enough loss-absorbing buffers — the role that bank equity plays.
If we had any kind of free market in banking, you would expect banks to have equity funding of at least 30 percent of total assets. But since the advent of deposit insurance in the 1930s, retail banks have been happy to have much less equity relative to debt, because the government is, in effect, providing a subsidy to debt.
Bankers are paid based on their return on equity, unadjusted for risk. As Prof. Anat Admati of Stanford University has been asserting, this is a big part of all our banking problems (see her critique of return on equity-based pay).
The small banks have a legitimate gripe, but it was not the focus of Friday’s hearing. The country’s mega-banks — for example, the six largest bank-holding companies — received a great deal of regulatory forbearance, as well as much more government support. In contrast, the smaller banks have received very little. The Troubled Asset Relief Program did make capital available to them on potentially advantageous terms, but taking that capital might have signaled that management thought there was a deeper problem.
The right approach to strengthening small-business lending in communities across the country is to encourage community banks to raise more equity (i.e., more capital). If they are unable or unwilling to do this, for example because of the so-called debt-overhang problem — that their debts to existing creditors weigh too much on new investors — we should allow and encourage new entrants.
Banking licenses could be made more readily available to well-capitalized entities with strong management teams and a proven commitment to serving local business. Existing community banks, as well as the politically powerful Independent Community Bankers of America, are unlikely to welcome such moves. But they would help small businesses and job growth.