FROM THE OFFICE OF PUBLIC AFFAIRS

Mr. Chairman, Representative LaFalce, Members of the Committee, I appreciate this opportunity to submit for the record the Treasury Department's views on the Farm Credit Administration's recent announcement that it will accept national charter applications from Farm Credit System associations.

The nation's interest in fostering reliable and competitive sources of credit to agriculture is strong. Our nation's system of agricultural lenders includes the Farm Credit System, a government sponsored enterprise established in 1916 to provide a reliable source of agricultural credit. My testimony will focus on the possible effects of the FCA's national charter proposal on agricultural credit markets. For broader issues of agricultural policy, I would defer to my colleagues at the Department of Agriculture.

I will first describe the relevant background and purpose of the Farm Credit System and then offer some views on the possible effects of national chartering. Through the course of my statement, I will attempt to answer the questions posed by the Chairman in his letter of invitation.

Congress established the first components of the Farm Credit System in 1916. At that time, farmers and ranchers were experiencing difficulty in obtaining both short- and long-term agricultural credit. The Farm Credit System was chartered to serve all creditworthy farmers and rural residents, not just the most profitable segments of the agricultural credit market.

The Farm Credit System was established as a government sponsored enterprise. GSEs are private sector entities created by Congress, and given a special set of benefits by Congress to accomplish a public purpose. Like other GSEs, the Farm Credit System is limited to a particular line of business - providing credit and related services in agricultural communities - and receives various government benefits that lower the System's operating costs and enable it to borrow at rates much lower than other financial institutions. Some of these benefits include an exemption from registering securities with the Securities and Exchange Commission and exemptions from federal, state, and local taxes (depending on type of System institution). GSEs are an exception to our general approach of avoiding differential treatment among financial institutions. The potential benefits that GSEs bring to a particular market must be balanced, therefore, against potential risks to the financial system and potential effects on market competition.

Today, the Farm Credit System funds about 27 percent of outstanding farm debt and has total assets of $89 billion. Of that $89 billion, $14 billion is funded by member capital, while $73 billion is funded by debt issued with the benefits of GSE status.

The Farm Credit System is unique among GSEs in one important respect. Whereas other GSEs were created to assist direct lenders - either by providing them a secondary market in which to sell certain types of loans or providing direct funding for such loans - the Farm Credit System is itself a retail lender. Because Farm Credit System associations lend much like banks, it is tempting to think of them as just another competitor in the agricultural credit market. But they are not just another competitor: they are a lender to which the government has given significant competitive advantages.

From its outset, the Farm Credit System was organized as a cooperative system under which the farmers that borrowed funds also owned the funding institutions. Farm Credit System historian W. Gifford Hoag characterized the creation of the System in the following manner:

The various parts of the cooperative Farm Credit System were authorized by Congress over a 17-year period - 1916 to 1933 - to meet extremely pressing needs of farmers, ranchers, and their cooperatives. In overly simplified terms, these needs can be summed up as having a dependable source of adequate credit, on terms suited to the particular needs of agriculture, from lenders who understood their problems.

The Farm Credit System has a complicated structure that emphasizes centralized, national funding of its liabilities but local credit judgment with respect to its assets. At the top of the Farm Credit System organizational structure are the regional Farm Credit Banks and the Agricultural Credit Bank, which are owned by, and provide funding for, direct lending associations, which in turn make loans to their farmer and rancher members. Neither the Banks nor the associations issue debt directly; instead they use the Federal Farm Credit Banks Funding Corporation, the System's fiscal agent. The Corporation issues debt obligations in the capital markets that are the joint and several obligations of all the Banks.

The FCA has historically granted the System's direct lending associations limited geographic territories. In most instances, a Farm Credit System customer may do business only with the Farm Credit System lender that serves the territory in which the customer conducts operations. As a general rule, existing FCA regulations:

• prohibit a Farm Credit System institution from serving customers operating beyond the institution's designated territory unless the Farm Credit System institutions designated to serve that territory consent;
• require notice whenever a Farm Credit System institution finances the out-of-territory activities of an existing borrower who also conducts operations and maintains headquarters in its chartered territory; and
• specify that out-of-territory lending should not constitute a significant shift of loan volume away from the institution's designated service area.

The FCA's recent announcement would allow Farm Credit System associations to apply for a national charter that would generally allow them to lend on a nationwide basis. Farm Credit System associations that do not apply for national charters would still have to abide by current out-of-territory lending regulations, but nationally chartered associations could lend in any territory. Because the FCA is an independent agency, it is not required to clear policies such as the national charter proposal within the Administration.

According to a USDA study, Farm Credit System lenders face three notable constraints on growth: limits on the range of financial services they may offer; capital standards that in the past made it difficult for new lending to be self-capitalizing; and geographic restrictions on their activity and growth. The FCA's national charter plan would reduce the third constraint. The FCA has argued that because not all Farm Credit System institutions give out-of-territory consent freely upon a customer's request, the process "impedes the System's ability to serve the needs of eligible customers as Congress intended."

The FCA has previously considered conditions under which associations may provide services outside of their chartered territories. For example, in 1993, the FCA issued a policy statement allowing System entities to offer financially related services outside of their assigned territories, provided they obtain the consent of all System institutions chartered to serve within those territories. In 1998, the FCA issued a proposed rule that would have permitted System customers to do business with the System lender of their choice without prior notification and consent. Thus, this "customer choice" proposal would have allowed System associations to lend anywhere without charter amendments. This proposal garnered a strong (and decidedly mixed) reaction from both System institutions and outside parties and was subsequently rescinded in January 2000.

FCA's recent announcement cites the need for Farm Credit System associations to operate more efficiently to better serve a changing agricultural marketplace. For example, an association serving one region would currently face the regulatory barriers discussed earlier in lending to an agribusiness located in another region. More broadly, whereas the Internet is nationalizing credit markets by allowing a firm to operate nationally from one location, a Farm Credit System association also would face those regulatory barriers in using the Internet to make loans out of its region.

The national charter plan does not attempt to alter the number or extent of the existing Farm Credit Bank districts. Instead, the plan would allow the associations through which the Farm Credit Banks make loans to compete for business in another Farm Credit Bank's district even though the Act maintains a regional structure at the Bank level.

Facilitating such lending may allow the Farm Credit System to operate more efficiently, and thus we can understand why the FCA would wish to pursue such a policy. Such a policy, however, also raises serious questions about the proper mission of the System.

We believe that granting national charters to Farm Credit System associations is a significant step that will accelerate a steady trend towards consolidation of the Farm Credit System. Even in the absence of national charters, the Farm Credit System has experienced rapid consolidation since its severe financial problems in the 1980s. Since enactment of the Agricultural Credit Act in 1987, the Farm Credit System has gone from 37 Federal Land Banks, Intermediate Credit Banks and Banks for Cooperatives to six Farm Credit Banks and one Agricultural Credit Bank, and from about 400 direct lending associations to 158.

Proponents of national charters argue that national charters could allow the System to operate more efficiently. As I will explain, however, such changes may also over time tend to diminish the local, cooperative nature of that System and have long-term effects on the competitiveness of the agricultural lending markets. In particular, they will allow expansion of a government sponsored enterprise - which are traditionally created to correct a market failure - at a time when markets are functioning competitively and even growing. Originally intended to complement the banking and thrift industries, the Farm Credit System may grow to mimic them.

First, Mr. Chairman, you and others have expressed concern that national charters may lead direct lending associations to focus on serving agricultural conglomerates at the expense of family farmers. Under this view, national charters could reduce the focus of the Farm Credit System associations on serving all eligible borrowers in their local areas.

Congress established the System's direct lending associations as member-owned cooperatives. Recent congressional enactments in this area have not changed this feature of the System. Throughout the 1987 debates over the Farm Credit System, Congress sought competition, efficiency, and an improved System structure. Yet Congress decided to achieve these goals through the continuation of the cooperative structure. The House report accompanying the Agricultural Credit Act of 1987 states: "Because the concept of a member-owned cooperative is appreciated to the highest degree at the local level, the fairest and most effective approach in dealing with the problem would be to down-size the middle layer (district banks) of the bureaucracy." These changes led to consolidation among the regional Federal Land Banks, Intermediate Credit Banks, and Banks for Cooperatives into the six Farm Credit Banks and one Agricultural Credit Bank we have today. Yet the changes preserved the notion that each Farm Credit Bank will operate within a given district.

In fact, even under today's structure the Farm Credit System has a mixed record of serving a wide range of agricultural borrowers. For example, a 1997 USDA report on credit in rural America reported that in 1995 the Farm Credit System had a 25 percent share of all farm debt, but only a 15 percent share of debt owed by commercial farms whose net worth was less than $250,000. In general, USDA research has found that farm operators borrowing from the Farm Credit System tend to be more financially secure than the average borrower, and that System debt is concentrated among more established and larger operators. For farm operators whose primary lender is the System, USDA reports that they own more land and are more likely to be in higher income brackets than farmers who borrow from commercial banks or the USDA.

Under its national charter announcement, FCA intends to monitor these issues through its supervisory process and ensure that associations granted national charters continue to serve local borrowers though a Local Service Area Plan. In effect, FCA is proposing to reproduce administratively - through supervisory review of lending patterns and marketing plans - the same mission focus that the System's structure has previously been intended to produce more systematically. While the FCA believes that this review will enhance pressure on the Farm Credit System to serve local, young, beginning, and small farmers, we believe that the System's current structure is an important part of maintaining local focus.

Second, Congress may wish to consider whether an expansion of the geographic reach of this GSE is warranted at this time. A 1997 USDA report on credit in rural America concluded that the farm sector "appears to be well served by a combination of private institutions, government-sponsored enterprises such as the Farm Credit System, and public agencies such as the USDA."

The Farm Credit System differs from the other GSEs in that its growth has been slower and its market share has decreased during the last 20 years. Since the early 1980s, the System's share of total farm business debt has declined from 34 percent to 27 percent, while commercial banks' share has increased from 22 percent to 40 percent. Again, however, it is crucial to note that the Farm Credit System institutions are government sponsored entities. Thus, shrinkage in their market share cannot be viewed in the same light as shrinkage in the market share of other institutions. Indeed, such shrinkage is clear evidence that there is now a competitive agricultural lending market of the type whose very absence originally motivated the creation of the System in 1916. Moreover, this market appears to be one where private sector innovation and efficiencies are sufficiently high to capture market share from a government-advantaged competitor. This is unequivocally good news.

Nonetheless, the Farm Credit System still retains roughly a quarter of the agricultural credit market. National operations and the power of the Internet may well allow it to cut its costs and lower the price for agricultural credit. While in the short term such a development would certainly be good for farmers and ranchers - or at least those farmers and ranchers who qualified for such credit - it might well diminish competition and innovation in the medium- to long-term by driving other competitors from the market. Although the competitiveness of the banking sector could possibly be maintained even in an environment of national charters, we are concerned that the advantages of GSE status could tip the balance in favor of the Farm Credit System.

Let me emphasize that one could conclude that this geographic expansion of the Farm Credit System is unwise, and still believe that the Farm Credit System has an important purpose in providing agricultural credit - particularly during hard times when banks and thrifts may be less willing to lend. In addition, there may be areas of this country where private sector lenders are not providing adequate agricultural credit, and where the Farm Credit System serves as an important source of credit (although that outcome may be more likely with the current, regional System than with a more homogenized, national system).

I would add one final note. Some have argued that the Farm Credit System needs these changes to remain competitive with those banks that, through the Gramm-Leach-Bliley Act of 1999, were given expanded access to funding from another GSE, the Federal Home Loan Bank System. The Treasury Department cited concerns with the Federal Home Loan Bank provisions of Gramm-Leach-Bliley throughout the legislative process. In conducting any review of GSE activities in agricultural credit markets, we urge Congress also to reconsider the role of the FHLBanks in agricultural credit markets.

Let me next discuss the effects of national charters on the Farm Credit System's safety and soundness. The Farm Credit System experienced severe financial problems in the mid-1980s. In the 1987 Farm Credit Act, Congress authorized up to $4 billion in Treasury-guaranteed bonds to assist the System. The Act also required Treasury to advance some of the interest payments on these bonds. Bonds worth $1.26 billion were actually issued and are still being repaid along with Treasury interest advances.

In our May 1990 report to Congress on GSEs, Treasury reported that individual Farm Credit System institutions were limited in their ability to diversify risk because their charters limit them to providing credit in specified regions. While we recommended at that time that the Farm Credit System develop a plan to deal with this situation, including further consolidation of System institutions, we did not recommend national charters or any form of intra-System competition. Since that time a great deal of consolidation has taken place within the Farm Credit System.

Other things being equal, individual direct lending associations operating with national charters would generally be able to achieve broader geographic diversification of business risk and credit risk than would be available to associations operating within a limited area. They may also recognize some efficiencies of scale. As associations grow, however, operations risk may also grow. Achieving overall risk reduction depends upon associations not entering markets they do not understand and upon the FCA being able to supervise associations with national operations.

More importantly, we do not believe that diversification at the association level would provide much if any diversification gains to the System as a whole. Unlike commercial banks, Farm Credit System Banks are jointly and severally liable for the Systems' debt obligations, and debt for all the Banks is issued centrally. A central insurance fund protects creditors from losses at any Bank in the System. From the point of view of the System's creditors, since the assets backing that credit do not change with national charters, diversification of individual associations through national charters would not necessarily reduce risk significantly.

Mr. Chairman, these are important issues that merit the attention you are paying them. The Treasury Department stands willing to assist you as you continue your consideration of these issues.