By Simon Johnson. My written testimony to House Financial Services, Subcommittee on Financial Institutions and Consumer Credit is here.
With unemployment back up to 9.2 percent, in the numbers that came out last week, the hunt is on for an explanation of why job creation has been so slow since the financial crisis of 2008. Some House Republicans think they have found a specific culprit: bank examiners.
In the view of Representative Bill Posey (R.) and a number of his colleagues on the House Financial Services Committee, bank examiners are clamping down on otherwise perfectly healthy banks – and forcing them to inappropriately classify some loans as “nonaccrual” (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 last Friday to discuss the merits of the matter.
I testified at the hearing and was not supportive of Mr. Posey’s legislation. On the subsequent panel of witnesses, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) testified – as the relevant regulators – and they were even more forcefully against the proposal.
George French, on behalf of the FDIC, said in his 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” – meaning whether regulators should look the other way when banks get into trouble, allowing them to be nicer to their borrowers and hopefully manage their way to recovery.
The problem with such forbearance is that it has a long history of leading not to recovery, but rather to much bigger problems. The Savings and Loan crisis, you may recall, began not as a major crisis but rather as a relatively small problem at some Texas mortgage lenders.
Congress responded to the complaints of these thrifts, which argued they had been poorly treated by various other changes in rules – and the result was legislation that gave these savings and loans enough additional rope (and forbearance) to hang themselves. The end result was that over 1,000 people went to jail and the taxpayer had to pay several hundred billion dollars to clean up the final 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 Bill 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 congressmen who spoke on Friday, I heard strong voices from Florida (Mr. Posey’s state), as well as 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 like they have more capital – i.e., greater shareholder equity – than they really do. The problem is that some of our community banks do not have big enough loss absorbing buffers – that is the role that bank equity plays; shareholders take the loss and (hopefully) prevent creditors from having to take any kind of hit.
If we still had any kind of free market in banking, you would expect to have equity funding – as a percent of total assets – of at least 30 percent. But, since the advent of deposit insurance in the 1930s, retail banks have been happy to fund themselves with much less equity relative to debt – because the government is providing effectively a subsidy to debt.
Bankers are paid based on their return on equity, unadjusted for risk. As Professor Anat Admati of Stanford University has been arguing, this is a big part of all our banking problems. (See her letter to the JPMorgan Chase board of directors: http://www.gsb.stanford.edu/news/research/admatiopenchase.html.)
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, on the other hand, perhaps taking that capital 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” – meaning 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 (ICBA), are unlikely to welcome such moves. But they would help small business and job growth.
An edited version of this post appeared this morning on the NYT.com’s Economix blog; it is used here with permission. If you would like to reproduce the entire column, please contact the New York Times.