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Home > News & Events > Speeches and Testimony |
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Speeches and Testimony |
ANDREW C. HOVE, JR. ON THE CONDITION OF THE BANKING AND THRIFT INDUSTRIES BEFORE THE SUBCOMMITTEE ON FINANCIAL INSTITUTIONS AND REGULATORY RELIEF
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
10:00 A.M.
Thank you, Mr. Chairman and members of the Subcommittee. I
appreciate this opportunity to testify on behalf of the Federal
Deposit Insurance Corporation on the condition of the banking and
thrift industries and the deposit insurance funds. I am pleased
to report that commercial banks and savings institutions are
experiencing a period of unprecedented prosperity. This
prosperity is due, in large part, to the ongoing economic
expansion, which at 78 months is now the third longest since
World War II. Buoyed by the economy's sustained growth and low
inflation, commercial banks have earned record profits in each of
the last five years. This, in turn, has helped the industry
build its capital to levels higher than at almost any time in the
last 60 years. Overall asset quality of commercial banks is also
strong, probably the best it has been since 1982, when asset
quality measures were added to bank financial reports.
The nation's savings institutions have benefited also from
the strong economy. In 1995, insured savings institutions posted
record earnings and the highest return on assets (ROA) since
1962. They would have posted new records last year if not for
the special assessment capitalizing the Savings Association
Insurance Fund (SAIF). The average capital levels of insured
savings institutions now exceed those of commercial banks.
In my remarks today, I will first discuss the overall
condition of the banking and thrift industries. I will then
discuss the continuing trend of consolidation and integration
among banks, thrifts, and other financial services providers.
Following that, I will discuss developments that pose potential
risks to insured institutions, including developments in credit
card lending, subprime lending, high loan-to-value ratio (LTV)
mortgages, syndicated lending, commercial real estate lending,
derivatives, and the so-called "Year 2000 Problem." I will then
update you on the condition of the two deposit insurance funds --
the Bank Insurance Fund (BIF) and the SAIF. I want to reiterate
my belief that the BIF and the SAIF, both now fully capitalized
and providing identical products to banks, thrifts, and
depositors, should be merged to help ensure a more stable deposit
insurance system. Finally, pursuant to this Subcommittee's
request, I will summarize the FDIC's Strategic Plan, which was
recently submitted to Congress pursuant to the Government
Performance and Results Act of 1993.
CONDITION OF THE INDUSTRY
Commercial Banking
The banking industry continues to operate at levels of
profitability that were unheard-of just a few years ago. Indeed,
the strength of the industry is revealed in nearly all standard
statistical measures. For the first six months of 1997, banks
have been on a pace to achieve record earnings for the sixth
consecutive year. More than 96 percent of all banks were
profitable in the first half of 1997 and two-thirds reported
higher earnings than in the same period of 1996. In the first
half of 1997, commercial banks earned $29.1 billion, which is
14.2 percent higher than for the same period last year, resulting
in an annualized ROA of 1.25 percent. The average ROA for all
banks should surpass 1 percent -- an industry benchmark -- for
the fifth year in a row, with two out of every three insured
commercial banks having an ROA of 1 percent or higher. From the
founding of the FDIC until 1993, the industry had never achieved
an average ROA of above 1 percent.
As a consequence of these earnings, the industry's equity
capital as a percentage of total assets is now at its highest
level since 1941 -- 8.44 percent of industry assets. Ninety-eight
percent of all commercial banks, representing more than 99
percent of total industry assets, meet or exceed the highest
regulatory capital standards. With such strong levels of
economic performance, it is not surprising that the number of
banks on the FDIC's "Problem List" at the end of the second
quarter of 1997 was 74 banks -- an all-time low -- with
consolidated assets of $5 billion at mid-year. More than 12
months have passed since the last failure of an insured
commercial bank. It has been more than 30 years since we had so
long an interval between bank failures.
The continued prosperity of commercial banks results from a
sustained period of favorable economic conditions and adjustments
and innovations by banks. Economic growth has supported strong
loan demand, while low and stable interest rates have helped
banks maintain high net interest margins. As a result, net
interest income growth has led to rising industry profits,
although asset growth has decelerated and margins have receded
somewhat from peak levels. The strong economy also has helped
limit loan losses and reverse the accumulation of nonperforming
assets in banks' portfolios. At the same time, through a greater
emphasis on providing new financial products and services, such
as mutual fund sales and management and brokerage services, banks
have increased non-interest income steadily over the past several
years. Finally, banks have been successful in controlling growth
in overhead expenses and their operations have become more
efficient.
One significant cost reduction for banks in 1996 and this
year has been lower deposit insurance premiums. Since the
recapitalization of the BIF in 1995, healthy banks have been
required to pay minimal or no deposit insurance premiums, saving
banks more than $5.5 billion annually on a pre-tax basis.
The Thrift Industry
There are two federal regulators for FDIC-insured savings
institutions. The FDIC supervises 582 state-chartered savings
banks. The Office of Thrift Supervision (OTS) oversees 1,270
state- and federally-chartered thrifts. These 1,852 institutions
held assets of $1.0 trillion and insured deposits of $676
billion as of June 30, 1997.
Savings institutions, like commercial banks, have enjoyed
strong earnings due to a healthy economy, improved asset quality
and stable net interest margins. In the first half of 1997,
savings institutions earned $4.7 billion, for an annualized ROA
of 0.94 percent. Over 96 percent of savings institutions were
profitable in the first half of 1997 and 38 percent had ROAs
exceeding 1.00 percent. The industry's 1997 earnings represent a
considerable improvement over 1996, when savings institutions
earned $7.0 billion and the industry's ROA was 0.70 percent.
Last year's earnings were reduced by a $3.5 billion one-time
special assessment to capitalize the SAIF, which reduced after-tax
earnings by an estimated $2.2 billion.
Today, the industry's equity capital ratio, 8.53 percent of
assets, is at a 46-year high. Ninety-nine percent of the savings
institutions currently meet the highest regulatory capital
standards and just four institutions are undercapitalized. Only
29 institutions with $2.8 billion in assets are considered
"problem" institutions, which is down from 35 institutions with
$7 billion in assets at the beginning of the year. No savings
institutions have failed since August of 1996.
Prospects for the Near Term
It appears that this period of unprecedented profitability
is likely to continue, at least in the near term. The greatest
potential threat to the status quo would be from a resurgence of
asset-quality problems, but there are few signs that such a
resurgence is imminent, either in the banking or the thrift
industries. With the exception of credit-card loans, bank loan
loss rates have not increased from cyclical low levels. Credit-card
loans, which I will discuss in more detail later, now
account for two-thirds of all loan charge-offs at commercial
banks. Although there has been an increase in the net loan
charge-off rate, the percentage of bank loans that are noncurrent
-- either 90 days or more past due on scheduled payments or in
nonaccrual status -- fell to 1 percent at midyear, the lowest
level in the 16 years that we have collected noncurrent loan
data.
Thrifts have seen significant improvement in asset quality
in recent years. Net charge-off rates have declined in each of
the last three years and through the first six months of this
year. Noncurrent loans are at the lowest level in the eight
years that noncurrent loan data has been collected for all
savings institutions. An improvement in real estate markets in
western states has been a major factor in improved asset quality
for savings institutions. In a reversal from prior years,
savings institutions in the western states now show noncurrent
loan levels below the national average.
INDUSTRY CONSOLIDATION
Banks and thrifts are earning extraordinary profits amid
dramatic changes in the financial marketplace. Recent
legislation, regulatory initiatives, judicial decisions and
technological advances have not only made it easier for banks and
savings associations to expand, consolidate, switch charters, and
acquire other institutions, but they have also blurred the lines
that previously separated the banking, securities, and insurance
industries. As a result, a wave of intra- and inter-industry
mergers and acquisitions has begun to rearrange the financial
services landscape. Pending deals and charter applications
indicate that this trend will only accelerate.
The passage of the Riegle-Neal Interstate Banking and
Branching Efficiency Act of 1994, for example, has resulted in a
wave of mergers and acquisitions within the banking industry.
During the first six months of 1997, a total of 325 commercial
banks and 60 savings institutions were absorbed by mergers and
acquisitions. Much of this activity is a result of multi-bank
holding company consolidation. The number of subsidiary banks
owned by the top 100 U.S. bank holding companies, for example,
dropped by approximately 20 percent in the first half of 1997,
driven mostly by consolidation of charters across state lines.
Although consolidation of multi-bank holding company operations
has been and continues to be significant, mergers and
acquisitions for the purposes of expansion still predominate.
Since enactment of the interstate banking law, approximately 44
percent of all commercial bank inter-state mergers and
acquisitions (as measured by the percentage of the seller's
assets) have represented expansions into new markets, while only
26 percent reflected within-market consolidations. The remaining
30 percent had both market expansion and within-market
components.
Recent changes in banking laws and regulations also have
made it easier for insured depository institutions to merge or
make acquisitions across banking lines. An August 1996 change in
the tax code, for example, virtually eliminated the costs of
converting a savings institution to a commercial bank.
Consequently, the banking industry has increasingly turned to
savings institutions as a source of deposit growth. Since the
beginning of the fourth quarter of 1996, 81 savings institutions
with almost $55 billion in assets have been absorbed into the
commercial banking industry. In addition, 22 savings
institutions with $16.7 billion in assets converted to commercial
bank charters.
How has all this merger activity affected the overall
industry numbers? As of June 30, 1997, there were 11,160 FDIC-insured
institutions -- 4,636 fewer than existed at the beginning
of this decade. Of that number, 903 represent failed
institutions that have been closed since 1990. Thus, we attribute
the net decline of 3,733 institutions to industry consolidation.
In contrast to the decline in the number of institutions, the
number of bank and savings institution branches actually
increased by 3,564 over the same period. To date, fears that
industry consolidation would lead to widespread layoffs have been
unfounded. Indeed, commercial bank and savings institution
employment has been trending upward in recent quarters. In June
1997, the number of full-time employees was 1.76 million, the
highest level in three years.
The banking industry has been consolidating while the
barriers separating commercial banking from other financial
service industries have been eroding. The combination of these
two trends is likely to have a profound effect on the future
structure of the industry. Since April of this year, for
example, six of the nation's largest bank holding companies have
bought securities firms. These acquisitions followed the Federal
Reserve Board's decision to raise the amount of revenues that
Section 20 securities subsidiaries of bank holding companies may
earn from the underwriting of bank ineligible securities.
Similar deals are also becoming commonplace among and
between insurers, brokerage firms, and thrifts. Just a few weeks
ago, Travelers Group announced that it would buy the investment
bank, Salomon Inc., in a deal valued at over $9 billion.
Travelers, which already owns retail stock broker Smith Barney,
also operates Travelers Life & Annuity, Primerica Financial
Services, Travelers Property Casualty Corp. and Commercial Credit
Company, and has an application pending for a federal thrift
charter. Five other insurance companies also have recently
applied to the Office of Thrift Supervision for thrift charters.
Clearly, changes are underway in the financial services
industries that are making distinctions between financial
services providers less relevant. Banks and savings institutions
appear financially well-prepared to adapt to the new marketplace.
POTENTIAL RISKS
As I have outlined previously, we are currently in the midst
of the most profitable period for banking in the post-World War
II era. As the deposit insurer, however, the FDIC must remain
vigilant for possible problems that could disrupt this
prosperity. Even now, banks' traditional businesses are coming
under greater competitive pressure than ever before. Innovations
in the capital markets, including the increasing securitization
of previously illiquid assets, are reducing the yields available
to banks from loans made to high-quality borrowers. Meanwhile an
expanding array of options available to savers is increasing the
cost and interest-rate sensitivity of bank liabilities.
In this highly competitive environment, some banks may take
more risks to increase short-term profits. For example, some
institutions may attempt to increase volumes on low-margin
business that may or may not offer adequate risk-adjusted
spreads; they may seek niches in higher-yielding, riskier
businesses; or they may cut costs in ways that ultimately reduce
their ability to manage risks. To sustain profits over the long
term, banks must allow for the possibility of a decline in the
economy and prudently balance risks and expected returns.
Developments in some segments of consumer lending,
including credit card lending, subprime lending in general, and
high LTV home-equity lending in particular, are noteworthy.
Developments in the market for syndicated commercial loans, a
resurgent commercial real estate market, the increased use of
financial derivatives and the "Year 2000 Problem" also have
attracted our attention. At present, the data do not suggest
that a substantial increase in bank failures is likely due to
these developments. Nevertheless, they warrant close scrutiny by
both bankers and their regulators.
Credit Cards
Problems in the credit card business have been well
publicized. Second-quarter 1997 earnings of credit card banks
(defined as institutions with total loans greater than 50 percent
of total assets and credit card loans greater than 50 percent of
total loans) declined by $334 million from first-quarter levels.
About one-third of this earnings decline was attributable to
higher loan-loss provisions, reflecting rising charge-off rates
on credit card loans. The remainder of the decline was due to
accounting adjustments and other nonrecurring expenses.
The annualized net charge-off rate on commercial banks'
credit card loans rose to 5.22 percent in the second quarter, up
from 4.92 percent in the first quarter and 4.48 percent in the
second quarter of 1996. As Chart 1 reveals, this is the highest
quarterly charge-off rate on credit card loans in the 14 years
that banks have reported this information. Losses on credit card
loans accounted for two-thirds of all loan charge-offs taken by
banks during the second quarter. Noncurrent credit card loans
also are at or near all-time highs. Some analysts have suggested
that charge-offs and delinquencies could be even higher were it
not that consumers increasingly are consolidating credit card
debt into home equity loans with lower monthly payment
obligations.
One factor in the high rate of credit card losses is the
continuing increase in consumer bankruptcies. Despite strong
economic growth and a 25-year low in unemployment, annual
personal bankruptcy filings in the U.S. have risen from around
one per thousand U.S. citizens in the mid-1970s to over four per
thousand in 1996. Over 1.1 million households filed for
bankruptcy protection during 1996, a rise of 29 percent from the
year before. Consumer bankruptcies continued to set new records
in the second quarter of 1997, both for the quarter (353,000) and
for the preceding twelve-month period (1.26 million). This trend
is particularly alarming in that it is intensifying at a time
when the economy is so strong. While new record levels are
expected in the near term, the rate of growth in bankruptcy
filings is expected to slow. VISA estimates that bankruptcy
filings will grow 14.8 percent in 1998.
Consumer credit quality has deteriorated in step with the
rise in bankruptcies. As evident in Chart 2, credit card charge-offs
have closely tracked the growth in bankruptcies. According
to many banks, bankruptcy accounts for about half of credit card
charge-offs. Many bankers report that, increasingly, bankruptcy
comes with no warning. Credit card accounts sometimes go from
current status to bankruptcy and charge-off without the usual
delinquency period. A recent article in the first quarter issue
of the FDIC's new Regional Outlook publication discusses the
causes of bankruptcy. A copy of the article is included as
Attachment 1 in the Appendix.
Causes other than bankruptcy also have reduced credit card
bank profits. Information technology and securitization have
helped ease entry into this business, thus increasing competition
and facilitating enormous growth in the supply of credit.
Information technology, including credit-scoring models, has
allowed lenders to segment customer bases and match product terms
with customer risk profiles, resulting in the proliferation of
credit card offers. Securitization of credit card receivables
has flourished, giving credit card lenders a relatively
inexpensive and plentiful source of funds. Increased competition
has produced balance transfer and "teaser rate" wars, which have
resulted in downward pressure on yields, as Chart 3 reveals.
In the event of an economic downturn, losses from bankruptcy
and credit card loans will probably increase. For example, the
1990-1991 recession was accompanied by increases in credit card
charge-offs of about 54 percent. Similarly, given current record
high consumer debt burden levels, an increase in interest rates
could have an adverse effect on consumers' ability to service
debt.
A related concern is the enormous size of the aggregate
outstanding lines of credit now available to credit card
borrowers. As of June 30, the amount of credit available, but
not used, was $1.547 trillion. Should the economy begin to slow
and unemployment begin to rise, borrowers may tap these lines to
maintain lifestyles until their economic fortunes improve.
However, in the interim, credit card banks that have extended
these lines could be exposed to greater losses.
Nevertheless, it appears that most institutions that
specialize in credit card lending have the financial strength to
absorb further increases in credit losses and additional erosion
of interest margins without jeopardizing their solvency. Card
interest rates are based, in part, upon a bank's loss experience.
Many major credit card banks have reported that they tightened
credit standards in 1996. However, many industry analysts
believe that charge-off rates may continue to rise this year
before they begin to decline some time in 1998. In the
meantime, developments in credit card lending warrant close
monitoring by both bankers and their regulators.
To this end the FDIC has undertaken several initiatives.
First, as part of a continuing program, the FDIC holds periodic
round table meetings with selected credit card speciality banks.
Participants assess emerging trends and risks in the retail
credit industry and discuss managing these risks. Second, to
evaluate credit card speciality banks, the FDIC has developed
quarterly analytical reports containing data on the distinctive
characteristics of these banks. The reports are used to monitor
trends and to help prioritize on-site examination scheduling.
Finally, the FDIC has developed specific procedures to examine
credit card specialty banks as well as other banks with extensive
credit card lending operations. A new examination manual that
outlines these procedures and addresses the specific risks of the
credit card industry was recently distributed to examiners.
While we do not believe that recent developments in the credit
card industry pose an immediate risk to the banking industry or
the insurance fund, we will continue to monitor them.
Subprime Lending
Faced with strong competition and shrinking margins to high
quality borrowers, many banks are pursuing subprime lending
strategies. Subprime lending most commonly refers to auto, home-equity,
mortgage, and secured credit card loans to borrowers who
have blemished or limited credit histories. Generally, the
characteristics of a subprime borrower include a history of
paying debts late, personal bankruptcy filings, or an
insufficient credit record.
In the past, subprime lending was primarily the domain of a
limited number of finance companies. The number of subprime
lenders has surged in recent years as more companies have been
attracted by significantly higher rates and fees earned on
subprime loans. Large and small banks are now participating in
credit card, auto, home-equity, and mortgage subprime lending,
although the extent of involvement is difficult to quantify
because subprime loans are not delineated in bank and thrift
financial reports.
The lack of a standard definition for a "subprime" loan
makes estimates of the extent of the market somewhat arbitrary.
However, as reflected in Chart 4, some sources estimate that,
during 1996, originations of subprime loans secured by
residences, including both home-equity and mortgage loans,
amounted to almost $150 billion. This compares to the estimated
$800 billion in originations of conventional mortgages. Subprime
auto loans have been estimated to range between $75 billion and
$100 billion, or about 20 percent of total auto loans
outstanding.
Increasing competition may compel some subprime lenders to
compromise underwriting standards and lower pricing in order to
protect market share. Financial difficulties reported by some
major subprime auto lenders highlight these concerns. As
recently as September 22, 1997, Standard & Poor's reported that
U.S. issuers of securities backed by subprime auto loans
sustained a two- to three-fold increase in losses. Reasons cited
were bankruptcies, increased origination of lower quality loans,
and lower auction recovery rates. Standard & Poor's also cited
increased competition leading to relaxed underwriting guidelines,
including higher advance rates and longer-term contracts.
Recent examinations revealed that a number of financial
institutions involved in subprime lending had failed to properly
assess and control the risks associated with this business. As
with credit card lending, increased losses on subprime loans are
occurring during relatively healthy economic conditions. The
repayment capacity of subprime borrowers may be especially
susceptible to downturns in the economy, which could exacerbate
the already high level of delinquencies and defaults typically
recorded on subprime loans.
The FDIC is concerned about the risks to insured
institutions that fail to manage the risks inherent in subprime
lending. In September 1997, a feature article in the FDIC's
Regional Outlook, which the FDIC furnishes to its examiners and
to all FDIC insured banks and thrifts, discussed some of the
risks involved in subprime lending in more detail. A copy of the
article is included as Attachment 2 in the Appendix. The FDIC
also issued a Financial Institution Letter to all FDIC supervised
institutions on May 2, 1997 warning of the risks associated with
subprime lending. These risks include more frequent and earlier
delinquencies and defaults, potential strains on underwriting and
collection resources, and difficulties in estimating recovery
values on repossessed collateral. Bankers also were told to
identify and understand the associated risks, design and
implement effective corresponding controls and establish prudent
limits before engaging in subprime lending or investing.
High Loan-to-Value Mortgages and Home-Equity Lending
Mortgage lending and home-equity lending have traditionally
presented low credit risks for banks, particularly when interest
rates are stable. To some extent, due to pricing pressures from
increased competition, market participants have sought higher
returns in the riskier sectors of these businesses. For example,
as shown in Chart 5, the percentage of conventional mortgages
with LTVs greater than 90 percent has grown dramatically. Recent
growth in subprime residential lending also has attracted
attention, as lenders that specialize in subprime home-equity
loans and subprime mortgages are beginning to show some signs of
stress. In April 1997, Moody's Investors Service lowered the
rating on subordinated debt issued by a leading originator of
subprime mortgage and home-equity loans because of the increasing
level of delinquencies in the issuer's loan portfolio and the
highly competitive environment for subprime home-equity loans.
Home-equity lending is a high-growth business for many
banks. One in four banks increased their home-equity lines by
more than 30 percent during the year ending mid-1997, as shown in
Table 1. Debt consolidation apparently has become the most
frequent reason for home-equity borrowing. Nonbanks that
expanded their mortgage lending capacity during 1993 have been
aggressively marketing to an increasing number of borrowers who
desire to consolidate their growing debt burdens, some now
offering loans in excess of collateral value (so-called 125
percent LTV programs). According to the Consumer Bankers'
Association's 1996 Home-Equity Loan Study, debt consolidation
accounted for 35 percent of home-equity lines of credit and 40
percent of closed-end loans. Prior to 1992, home improvement was
the primary reason for home-equity borrowing. Unlike funds lent
for home improvement, the proceeds of a debt consolidation loan
do not enhance a lender's collateral value. Also, funds are
extended to many who may be facing difficulties in meeting their
existing consumer debt service.
Rapid growth in home-equity lending has been accompanied by
signs of relaxed underwriting. Chart 6 shows the foreclosure
rates for securitized closed-end loan pools originated in 1995
and 1996 versus 1994. While these data are based mostly on pools
originated by nonbank subprime lenders, the sharp increase in
delinquency rates for loan pools originated in 1995 and 1996 is
worth noting. The third quarter issue of the FDIC's Regional
Outlook contains an article that discusses trends in the home-equity
securitized market. A copy of the article is found as
Attachment 3 in the Appendix.
In our effort to monitor and control potential problems in
high LTV and home-equity lending -- as well as in syndicated
lending and commercial real estate lending, which I will discuss
shortly -- the FDIC has implemented an ongoing underwriting
standards survey that examiners complete at the conclusion of
each safety and soundness examination. The survey assesses
changes in the bank's underwriting standards and compares these
standards with those of other area banks. While our survey
results show few weaknesses in the banks we directly supervise,
as competition with nonbanks intensifies, any trends toward
loosening underwriting standards will be closely monitored. In
addition, Appendix A to Part 365 of the FDIC's Regulation on Real
Estate Lending Standards sets forth specific guidance on real
estate lending policies that banks should employ. For example,
one section of Appendix A sets forth maximum loan-to-value limits
for different types of real estate loans and specifies that loans
exceeding such limitations should be reported to the
institution's board of directors at least quarterly.
Syndicated Lending
Syndicated loans are large loans that are divided into
smaller portions and sold to investors who then have a
proportionate interest in the original underlying loan. As
indicated in Chart 7, the current boom in syndications could
result in an annual volume approaching one trillion dollars, more
than double the level in 1993 and quadruple the level in 1991.
While 40 percent of syndicated loans have been used to refinance
existing debt, the amount of syndicated loans made to finance
mergers and acquisitions is now comparable to the level in the
1980s.
Intense competition is transforming this sector, as
investment banks are making notable inroads into a sector that
traditionally has been dominated by banks. As part of a so-called
"one-stop shopping" strategy, syndicated lending enables
investment banks to offer a complete array of advisory services
and financing capabilities.
As a result, spreads have narrowed significantly over the
last three years, especially for some of the lowest-rated
borrowers, though this decline in spreads has begun to level off.
In some cases, loans to the highest-quality borrowers are
reportedly being made primarily to preserve business
relationships and are resulting in almost no risk-adjusted
profit.
One concern is that a significant percentage of syndicated
loans are being purchased by smaller banks, which, in some cases,
may not be thoroughly reviewing the credit analysis. These
smaller purchasing banks, however, may not enjoy the
"relationship value" that, for the loan originator, may offset
the narrow spreads. As mentioned earlier, for these and other
reasons, the FDIC has implemented an underwriting standards
survey to assess changes in a bank's underwriting standards and
to compare these standards with those of other area banks. The
FDIC will continue to monitor developments in syndicated lending
closely.
Commercial Real Estate Lending
Given the significant losses to the insurance funds due to
commercial real estate problems during the last banking crisis,
the FDIC follows developments in real estate lending very
closely. Banks are currently leading a resurgence in commercial
real estate lending. About 28 percent of banks increased their
total commercial real estate and construction lending by more
than 30 percent during the twelve months ending June 30, 1997, as
set forth in Table 1, and about 23 percent of all banks with less
than $1 billion in assets have total exposure in these two
sectors of more than 200 percent of equity capital. High
concentrations or rapid growth in a particular lending segment
are not necessarily indicators of problems on the horizon.
Nevertheless, any significant concentration of credit in a
particular sector will be monitored closely.
Some analysts have expressed concerns about certain property
types in particular locations. However, many metropolitan
commercial real estate markets are seeing rising prices and rents
and falling vacancy rates as the excess space created during the
1980s and early 1990s continues to be absorbed.
Further, there has been notable growth in the use of
Commercial Mortgage-Backed Securities (CMBS) and Real Estate
Investment Trusts (REITS) to finance the resurgence in commercial
real estate. According to Commercial Mortgage Alert, outstanding
CMBS reached $125 billion in 1996 on a record $30 billion of new
issuance. Similarly, REITS have become a stronger force in real
estate finance and have rapidly increased their market
capitalization. These innovations can improve market efficiency
by providing continuous pricing benchmarks through daily share
price movements and thus enforce discipline upon developers and
lenders, which may in turn help prevent excessive development and
dampen the severity of real estate cycles. However, some
analysts have argued that the appetite for REIT investments,
combined with the premiums that the trusts can pay for
properties, may push the price of commercial space beyond
sustainable levels, thereby potentially amplifying cyclical
swings in real estate values. Again, as with other innovations
in the industry, we will monitor developments closely.
Financial Derivatives
Broadly defined, a financial derivative is a contract whose
value depends on, or derives from, the value of an underlying
asset, reference rate, or index. Financial derivatives are
contracts which are principally designed to transfer price,
interest rate and other market risks, without involving the
actual holding or conveyance of balance sheet assets or
liabilities.
Most risks inherent in financial derivative instruments are
present in varying degrees in more traditional financial
institution products and activities and can largely be assessed
and evaluated in similar fashion. The complexity of financial
derivatives is largely due to the manner in which these risks are
combined. The difficulty in determining market values, the
potential for increased leverage and the speed with which
external market forces can affect value heighten the difficulty
of accurately assessing the magnitude of these risks.
Despite their complexity, financial derivatives can be
important risk-reducing tools. Nevertheless, their complexity,
their enormous notional value and their concentration at a small
number of banks merit close FDIC supervision to ensure that banks
maintain acceptable capital levels, suitable expertise and
sufficient management controls for these activities. In an
effort to ensure that examiners appropriately review an
institution's use of derivatives, the FDIC issued an April 1994
Regional Directors Memorandum concerning derivatives in general
and a follow-up Regional Directors Memorandum specifically on
credit derivatives in August 1996.
Off-balance-sheet derivative contracts (futures, forwards,
swaps and options) grew rapidly during the early 1990's. From
the end of 1990 through the first quarter of 1995, the notional
value of total outstanding derivative contracts rose from $6.8
trillion to $17.3 trillion, a compound annual rate of increase of
24.6 percent. During 1995, there was somewhat of a lull, with
total contracts actually decreasing 4.4 percent in that year's
fourth quarter. In 1996, however, the market rebounded with
strong increases and, during the first half of 1997, the market
experienced its strongest growth in several years with a 16.1
percent increase in off-balance-sheet derivatives contracts.
Futures and forwards are the most prevalent type of contract at
$9.1 trillion, followed by swaps at $8.7 trillion, and options at
$5.4 trillion. The most commonly used contracts were interest
rate contracts, followed by foreign exchange agreements.
Using the FDIC's definitions, in the five years prior to
June 30, 1997, the notional amount of off-balance-sheet
derivatives at commercial banks has increased by more than 175
percent, from $8.4 trillion to $23.3 trillion. Currently, 459
commercial banks, down from a peak of 679 in early 1993, hold at
least some off-balance-sheet derivatives, but the seven largest
dealer/traders account for 93 percent of all off-balance-sheet
derivatives. Both the income and balance sheet results of banks'
trading activities in off-balance-sheet derivatives exhibit
considerable volatility. In the last eight quarters, trading
gains and fee income attributable to these activities have ranged
from as much as $2.4 billion to as little as $1.5 billion. The
earnings impact of off-balance-sheet derivatives held for
purposes other than trading has been mixed. For example, through
the first six months of 1997, 417 banks indicated that these
contracts had an effect on their income, suggesting that they
were being used to hedge against interest rate risk. Of those
417 banks, 54 reported lower net interest income as a result of
holding off-balance-sheet contracts, while 363 banks reported
higher net interest income. Most banks -- approximately 8,849 --
do not have any off-balance-sheet financial derivatives; any
interest rate risk management takes place on-balance-sheet.
The Year 2000 Problem
The financial institution industry is confronted with a
unique challenge unrelated to the traditional risks associated
with the industry. This challenge results from the method in
which dates have been recorded in information technology systems
and components. For decades, information technology platforms
have represented the year as two digits, compared to the normal
four digit format. On January 1, 2000, information technology
systems that continue to use the two digit format will be unable
to differentiate the year 2000 from the year 1900. This
inability will cause mainframes, networks, personal computers,
and other time-dependent technology to operate improperly. For
example, the integrity of arithmetic calculations and date
comparisons will be compromised.
The financial institution industry is especially exposed to
Year 2000 issues because many of its services and products
require calculations that are date-dependent. For example,
mortgage amortization, interest calculation, check processing,
wire transferring, and dividend payment functions require date
references. Ultimately, should financial institutions be unable
to deliver their products or services to customers, their
business could be threatened.
The FDIC, in conjunction with the Federal Financial
Institutions Examination Council (FFIEC), has issued an
interagency statement that provides guidance on the activities
insured financial institutions and data service providers need to
undertake to ensure that all information technology systems and
components are capable of recognizing dates in the Year 2000 and
beyond. In addition, the interagency statement outlines the
strategy that the banking regulators will use to ensure that Year
2000 issues are resolved.
The FDIC, along with other members of the FFIEC, is using a
multi-step program to verify that insured financial institutions'
information technology systems are Year 2000 compliant. The
first part of the program, scheduled for completion by the end of
1997, assesses the current status of their Year 2000 planning
efforts through an examiner questionnaire. This part of the
program also includes an assessment of the status of multi-regional
data processing servicers, other large independent
servicers and the largest vendors of bank software. This
assessment is particularly important to the FDIC, since many of the banks
we supervise are smaller banks that are more dependent on servicers.
Since March, the FDIC and state banking authorities have conducted
Year 2000 surveys on approximately 4,800 FDIC-supervised financial
institutions -- approximately 77 percent of FDIC-supervised institutions --
and 119 third-party servicers and software vendors -- approximately
81 percent of the servicers and vendors that the FDIC will assess.
Other FFIEC members will assess other servicers and will share their
assessments with the FDIC. The results indicate that institutions are
generally aware of the Year 2000 problem. However, in some instances,
senior management and outside directors do not fully understand the risk
posed by this issue. The FDIC, in cooperation with the other federal
banking regulatory agencies and state supervisory authorities, will
continue its efforts to raise awareness of the seriousness of Year 2000
issues.
The results of the first phase of the multi-step program are
being used to plan the next phase, on-site supervisory reviews.
On-site supervisory reviews of third-party servicers and software vendors
assessed by the FDIC are expected to be completed by the end of
1997. On-site supervisory reviews of FDIC supervised
institutions are expected to be completed by mid-1998.
Insured financial institutions identified as having
significant problems addressing Year 2000 issues will be
supervised by FDIC examiners working closely with these
institutions to mitigate these problems. Supervisory action, including
formal enforcement action if warranted, may be taken if an institution
fails to address this issue in a timely fashion. In addition, the FDIC
is working with other federal regulators to develop an outreach program
that will communicate the regulators' issues and concerns regarding the
Year 2000 problem to vendors or data service providers of insured
financial institutions.
CONDITION OF THE INSURANCE FUNDS
The two deposit insurance funds managed by the FDIC reflect
the condition of the banking and thrift industries. They are
well capitalized and are well insulated against foreseeable
losses. With low insurance losses, both funds are prospering
even though, under our risk-based premium system, the best-rated
banks and thrifts are not currently assessed for deposit
insurance coverage.
The Bank Insurance Fund had a balance of $27.4 billion on
June 30, 1997, which was 1.35 percent of estimated insured
deposits. Since reaching the Designated Reserve Ratio of 1.25
percent in the second quarter of 1995, the BIF has continued to
grow, both through investment earnings and through the recovery
of reserves previously set aside for losses attributable to
anticipated failures and assets in liquidation. Some
institutions earlier projected as likely failures are no longer
considered a threat to the fund. With only $26 million remaining
in loss reserves as of June 30, 1997, however, comparable
recoveries of reserves are unlikely in the near term. The fund
also earned more than $700 million in interest income in the
first half of 1997. Assessment revenue fell to just $13 million
during that six-month period, compared to $37 million for the
same period in 1996, as the percentage of the healthiest BIF
members, which pay no premiums, rose to 95 percent.
Following the special assessment of $4.5 billion last fall
to reach full capitalization, the Savings Association Insurance
Fund is healthy. The $9.1 billion fund was 1.32 percent of
estimated insured deposits on June 30. With minimal receivership
activity, the fund is very liquid, and investment earnings
totaled $262 million for the first six months of 1997. Despite
an assessment base that is roughly one-third that of the BIF,
SAIF assessment revenue was slightly higher for the first half of
1997, at $14 million, than that of the BIF due to a somewhat less
favorable distribution of SAIF members in the risk-based
assessment matrix. Nevertheless, nearly 90 percent of all SAIF
members qualify for the best rating and pay zero premiums.
It has been more than one year since either fund experienced
a failure. The near-term expectations for both funds remain
favorable, but we do not -- and cannot prudently -- believe that
current conditions will continue indefinitely. Steps to further
strengthen the federal deposit insurance system should be taken
now, when both funds are strong and insured institutions are
prosperous. In particular, the BIF and the SAIF should be
merged. The Deposit Insurance Funds Act of 1996 (the Funds Act),
which capitalized the SAIF, recognized the need for a merger of
the deposit insurance funds. The SAIF insures far fewer, and
more geographically concentrated, institutions than does the BIF,
and consequently faces greater long-term structural risks. A
combined BIF and SAIF would have a larger membership and a
broader distribution of geographic and product risks and would be
stronger than the SAIF alone. With both funds fully capitalized
and their members healthy and profitable, the SAIF and BIF
reserve ratios are very close to each other and should remain so
throughout 1997. This means that a merger of the two funds would
not result in a material dilution of either one. Under the Funds
Act, Congress made the merger of the BIF and the SAIF contingent
upon there being no savings associations, and we are hopeful that
Congress will address fund merger issues in the context of
enacting broader financial modernization legislation. However,
regardless of what happens with comprehensive financial
modernization legislation, I urge you to pass legislation that
merges the two insurance funds, as contemplated by the Funds Act,
while both funds are fully capitalized. Although we are not
currently predicting losses to the funds, if either the banking
or thrift industries were to encounter serious difficulties in
the future and losses to the related funds resulted, merger of
the two funds could become problematic.
SUMMARY OF THE FDIC'S STRATEGIC PLAN
As the Subcommittee has requested, let me now summarize the
FDIC's Strategic Plan that was recently submitted to Congress
pursuant to the Government Performance and Results Act of 1993
(the Results Act), which took effect this year. The FDIC
strongly supports the Results Act. We are proud of our planning
accomplishments over the past several years. While the Results
Act applies the principles of sound business management to the
Federal government, the FDIC has used strategic planning and
performance measurement principles for years prior to the
enactment of the Results Act.
The FDIC's Strategic Plan for 1997-2002 reflects our
increasing emphasis on risk management. The Plan includes
vision, values and mission statements that reflect our commitment
to risk management, the safety and soundness of our banking
system, fairness in the provision of financial services, and a
positive environment for our employees to achieve our mission.
The Strategic Plan includes goals, objectives and strategies
for the FDIC's three major program areas: Insurance;
Supervision; and Policy, Regulation and Outreach. The Insurance
program area comprises three functional areas identified as Risk
Assessment; Resolution of Failing Institutions; and Receivership
Management. This program area reflects the FDIC's role as
deposit insurer in assessing potential risks to the insurance
funds and proactively minimizing risks and costs to the insurance
funds. In addition, the Insurance program area reflects the
Corporation's role of minimizing costs to the funds through the
orderly and "least costly" resolution of failed or failing
institutions, and by effectively managing receivership
operations.
The Supervision program area encompasses two functions
identified as Risk Management-Safety and Soundness, and Risk
Management-Compliance and Enforcement. The Supervision program
area addresses the manner in which the FDIC fulfills its role of
promoting the safety and soundness of insured depository
institutions and fairness in the provision of financial services.
The Policy, Regulation, and Outreach program area comprises
four functional areas: Consumer Affairs; Policy Leadership;
Community Affairs and Outreach; and Outreach-Safety and
Soundness. In addition to the Supervision program area, this
program area describes how the FDIC fulfills its role of
implementing statutes related to consumer protection, fair
lending, and deposit insurance.
In addition, the FDIC's Strategic Plan addresses the
resource strategies that will assist the FDIC in meeting its
goals and objectives. In the staffing area, the FDIC is
continuing to transfer staff from the failing institution
resolution and liquidation areas into risk assessment,
supervision, and compliance, in accordance with our increased
emphasis on risk management. We also are pursuing technological
initiatives that will improve examiners' ability to evaluate the
financial condition of institutions and their compliance with
fair lending and other laws. The Strategic Plan also includes
annual performance measures that relate to the Plan's long-term
goals and objectives.
While the Strategic Plan describes measures in general
terms, the FDIC's Annual Performance Plan (which we referred to
in prior years as our Corporate Business Plan) specifies
performance goals or target levels for each measure. Performance
is compared to these targets to determine achievement of our
objectives. The FDIC's first Business Plan was developed in 1996
for calendar year 1997 and included performance targets for each
of the FDIC's program and functional areas in the Strategic Plan.
The 1998 Annual Performance Plan will set forth our target levels
of performance for the year for each of the eight functions of
the three major program areas in the Strategic Plan and include
all of the elements required by the Results Act for Annual
Performance Plans. We do not expect the performance measures or
targets to change significantly over those that are in place in
1997.
The Strategic Plan outlines key external factors that could
affect achievement of the FDIC's strategic goals. Examples of
external factors are domestic or international economic
developments, especially as they relate to the banking industry;
the likely actions of Congress and other regulators of financial
institutions; and the general business environment in which
financial institutions operate.
With regard to program evaluation, the FDIC evaluates its
program performance through a Quarterly Performance Reporting
process. In May of this year, the FDIC initiated the reporting
of our progress toward the performance targets established in the
1997 Business Plan. This report measures the FDIC's progress in
meeting 27 performance targets in the FDIC's eight functional
areas in the Strategic Plan and is reviewed quarterly by the
FDIC's Operating Committee, which is comprised of the Chairman
and officers of the Corporation. Beginning in 1998, the
Quarterly Performance Report will be presented to the FDIC Board
of Directors. This process holds managers accountable for
achievement of their goals and provides feedback, which, in turn,
allows us to revise goals, objectives and performance measures as
appropriate. Work continues in this area as we move towards a
more formalized program evaluation function in 1998.
The link between planning and budgeting is critical for the
success of our planning process. The only programs that are
funded through the FDIC budget are those that have been approved
in the Strategic Plan or the Annual Performance Plan.
Implementation of the Strategic Plan has resulted in cost savings
throughout the FDIC since 1995, and those savings are projected
to continue.
The FDIC continually consults with various stakeholders
regarding our Strategic Plan. We inform these key groups of our
strategic planning process and strategic initiatives on an
ongoing basis through participation of Board members, Division
and Office Directors and senior staff in outreach opportunities,
speeches to industry trade groups, and participation in various
community/consumer group activities. The Strategic Plan also was
presented to and discussed with our Board of Directors at public
meetings in April 1995 and April 1997. The Plan is also posted
on our Internet site.
As required by the Results Act, the FDIC has been working
closely with the other depository institution regulatory agencies
to address programs that transcend the jurisdiction of each
agency. In this connection, the FDIC is participating in an
interagency working group to address and report on issues of
mutual concern.
CONCLUSION
In conclusion, I am pleased to report that the condition of
the banking and thrift industries is excellent. Record profits,
accompanied by strong capital ratios and an absence of failures,
make for a healthy industry. The FDIC sees no immediate threat
to this situation. However, we will continue to closely monitor
developments in the financial industry for potential problems,
particularly in credit card lending, subprime lending, high
loan-to-value ratio mortgages, syndicated lending, commercial real
estate lending, derivatives and the Year 2000 issue, to ensure
that institutions are prepared to respond if problems arise in
the future.
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Last Updated 6/25/99
communications@fdic.gov
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