Six Causes of the Credit Crunch

Economic Review—Third Quarter 1993 1
Robert T. Clair Paula Tucker
1
Senior Economist and Policy Advisor Student
Federal Reserve Bank of Dallas University of Texas at Austin Law School
M
any bankers, legislators, borrowers, and
regulators have expressed their views about
the cause of the credit crunch. Like the blind men
examining an elephant, each has an opinion that
has been formed from his perspective. Each has
characterized the problem and potential solutions
differently. None are completely correct or com-
pletely wrong. Bankers cite the lack of high quality
loan demand. Legislators blame overzealous regu-
lators. Borrowers say banks are too conservative.
Regulators encourage bankers to lend and tell
their examination staffs to facilitate the extension
of credit but maintain the safety and soundness of
the banking system.
Many economists studying the credit crunch
explain it as a cyclical decline in credit demand.
They often suggest that the cyclical swing is
reinforced by structural changes in the demand
for credit. These economists have minimized the
numerous important factors that have reduced the
ability of banks to supply credit or, at a minimum,
have increased the cost of providing it.
In this article, we view credit crunches as
localized events that occur at different times in
different parts of the country. The Texas banking
industry provides an important case study. The
causes of the Texas credit crunch are highly
similar to the causes of credit crunches that have
developed elsewhere in the country. We focus on
the past seven years because the contraction of
bank credit began in Texas in 1986.
While demand may play an important part
in the decline in loans outstanding during some of
this period, we focus on the factors affecting the
supply of loans from banks over the past seven
years. While there are other sources of credit to
business, banks continue to be vitally important,
especially to small and mid-size businesses (Ellie-
hausen and Wolken 1990). Many of the factors
that are limiting credit supply from banks also
affect other suppliers of credit. In some cases,
however, the factors limiting credit from banks are
unique to banks and place banks at a competitive
disadvantage. As discussed in the next section, the
definition of a credit crunch is fundamentally
related to the supply of credit, as opposed to the
demand for it. The following section presents the
complexity of the credit crunch as it developed in
Texas, where supply was reduced at both finan-
cially healthy and unhealthy banks. In the remain-
der of the article, we present six general factors
that caused the supply of credit to contract.
What is a credit crunch, and are we in one?
The economics profession is unclear as to
what constitutes a “credit crunch.” The crucial
differences in definition depend on the cause of
the contraction and whether credit is rationed by
means other than price.
Bernanke and Lown (1991) define a credit
crunch as a decline in the supply of credit that is
abnormally large for a given stage of the business
cycle. Credit normally contracts during a reces-
sion, but an unusually large contraction could be
seen as a credit crunch.
In their analysis, Bernanke and Lown com-
pare the contraction in credit during the most
1
Paula Tucker is also a former economic analyst and writer
for the Federal Reserve Bank of Dallas.
Six Causes of the Credit Crunch
(Or, Why Is It So Hard to Get a Loan?)
Federal Reserve Bank of Dallas 2
recent recession to those in the previous five
recessions. Total loans at domestically chartered
commercial banks grew only 1.7 percent during
the 1990–91 period, compared with an average of
7.1 percent during the previous five recessions.
They conclude that there has been a credit crunch.
Bernanke and Lown attribute this reduced
lending activity to demand and supply factors.
Loan demand has been weak because borrowers’
balance sheets have been weaker than normal,
and as a result, borrowers have been less credit-
worthy than usual. The supply of credit has been
reduced by the decline in bank capital caused by
severe loan losses during the recession (Clair and
Yeats 1991). Bernanke and Lown’s analysis indi-
cates that the demand factors have been far more
important, accounting for three-fourths of the
decline in lending in New England.
There is a disturbing dissonance created by
the Bernanke and Lown definition of a credit
crunch, the results of their analysis, and their con-
clusion that there was a credit crunch. They define
the credit crunch as an abnormally large decline
in the supply of credit. They argue that demand
factors largely caused the reduction in lending.
They then conclude that there is a credit crunch.
A second problem with the Bernanke and
Lown analysis is their use of national data to
determine if a credit crunch exists. Their cross-
sectional analysis using state-level data assumes
the imperfect substitutability of bank and nonbank
credit and of bank credit from banks located in
different states. Samolyk (1991) provides empirical
evidence supporting this assumption. If bank credit
cannot flow perfectly across state lines, however,
then the problems of a credit crunch would be
more likely to develop at the state level, not the
national level, unless a nationwide economic shock
caused the decline in bank capital.
The second definition of a credit crunch
relies not on the contraction in lending but on the
microeconomic principle of a shortage. If at the
current market price the demand for a good
exceeds the supply, then there is a shortage. The
available supply will be rationed but by some
means other than pricing. Nonprice credit rationing
may occur even in a market that might not be
described as experiencing a credit crunch (Stiglitz
and Weiss 1981). Owens and Schreft (1992) define
a credit crunch as a period of sharply increased
nonprice rationing.
Owens and Schreft review historical episodes
of nonprice rationing—that is, credit crunches that
were accompanied by binding interest rate ceilings,
credit controls, or coercive posturing by adminis-
trative officials and bank regulators to discourage
banks from lending. In the current recession,
researchers argue, administrative officials and bank
regulators have actively encouraged banks to
lend.
2
Owens and Schreft do state that there was
probably nonprice rationing in loans secured by
real estate, resulting from bank examiners’ reaction
to real estate loan losses. They cite the statements
made by Robert Clarke, then comptroller of the
currency, that discouraged banks from making
real estate loans.
Owens and Schreft conclude that there is
not a general credit crunch, but there might have
been a sector–specific crunch in real estate. Since
nonbank providers of credit also contracted their
lending, Owens and Schreft attribute the decline
in lending to ebbing loan demand.
The Owens and Schreft definition of a credit
crunch has intuitive microeconomic appeal but
may not provide the insights needed for economic
policy analysis. Their definition does not consider
actual lending activity. Consequently, a “credit
crunch” can occur during a period of expanding
credit as easily as during a contraction of credit.
Furthermore, Owens and Schreft dismiss
anecdotal evidence from borrowers. They may be
correct that borrowers would complain during any
period of tight credit, but the type of complaint
could be quite different. During nonprice rationing,
borrowers complain about not being able to get a
loan at any price. During periods of simply tight
credit, borrowers complain about the cost of credit.
Despite their differences, both the Bernanke–
Lown and Owens–Schreft studies agree that a
decline in credit demand explains the major part of
the credit contraction, and both find little support
2
At the same time that Bush administration officials were
encouraging additional lending, Congress was holding
hearings on bank failures and sending a signal to examiners
that they should be conservative if they wished to avoid
testifying before Congress.
Economic Review—Third Quarter 1993 3
for the explanation that more stringent bank
examination practices account for the contraction
in loan supply. Owens and Schreft link the decline
in credit demand to the deterioration of real estate
asset values, similar to the Bernanke and Lown
view of weakened balance sheets. In determining
if the nation is in a credit crunch, Bernanke and
Lown cite the abnormally slower growth of credit
as a sign of the credit crunch, while Owens and
Schreft see few signs of nonprice credit rationing
and conclude that there is no general credit crunch.
In ascertaining that demand factors are a
primary cause of the decline in bank credit, both
studies cite the lack of credit supply response
from nonbank sources of credit. Nonbank sources
of credit to businesses are growing increasingly
important (Pavel and Rosenblum 1985). Approxi-
mately 25 percent of small and mid-size businesses
obtain credit from nonbank sources (Elliehausen
and Wolken 1990).
If bank credit alone were being rationed or
constrained, both studies argue, other providers
of credit should have increased their activity. Most
nonbank sources of credit to corporate businesses
have contracted during the 1990–91 recession.
From 1989 to 1991, not only did the annual flow
of funds from bank loans contract but so did the
flow of funds from finance companies, commercial
paper, mortgages, and trade credit. At the same
time, the flow of funds needed for capital expen-
ditures contracted sharply. These national aggre-
gate data are consistent with the hypothesis that
demand factors have driven the credit contraction.
In a comment on the Bernanke and Lown
study, Benjamin Friedman points out that they
assumed that other nonbank credit providers did
not suffer the same constraints (Bernanke and
Lown 1991). If loan losses have caused capital to
decline at banks, might not similar losses reduce
the capital of nonbank creditors, such as insurance
companies? Michael Keran (1992), vice president
and chief economist of the Prudential Insurance
Company of America, has acknowledged that
financial intermediaries other than banks have also
suffered declines in capital resulting from real
estate and other loan losses.
Because of their analytical approaches, both
of these empirical analyses have misdated the
beginning of the credit crunch. The Bernanke and
Lown analysis uses national data that mask impor-
tant differences among various regions of the
country. The Owens –Schreft analysis begins in
late 1989 and focuses on New England. Texas
suffered a severe contraction of its economy and
of bank credit during the last half of the 1980s
when the national economy was growing. By
failing to examine state-level data, both studies
misdate the start of the credit crunch by several
years and fail to establish its regional nature
(Rosenblum and Clair 1993).
Because Texas began its credit crunch earlier,
Texas is a better case study to examine long-term
effects. Texas’ banking industry was so severely
affected that even after the state’s economy began
a recovery in 1987, the banks did not increase
their lending. Even though Texas’ economy outper-
formed the nation’s during the 1990–91 recession
and experienced only a modest slowdown, lend-
ing at Texas banks did not increase for six years.
The life cycle of a credit crunch:
the Texas experience
Until 1987, Texas’ loan cycle was in line
with the regional economic cycle. During the
economic expansion of the first half of the 1980s,
loans extended by Texas banks more than doubled
from $52 billion in 1980 to $119 billion in 1985.
In the midst of continued growth in the national
economy, Texas entered a recession, triggered by a
precipitous decline in oil prices in 1986. Declines
in lending during an economic downturn are
normal.
The abnormality in the Texas lending pattern
surfaced about 1987. Despite an economic recovery,
lending continued to decline. From 1987 to 1990,
lending declined another 30 percent, even though
employment increased 6.8 percent. Even the
modest increase in loans outstanding that began
in 1992 does not reflect new lending as much as it
does acquisition of failed savings and loan associa-
tions (S&Ls), their assets, or assets from other
nonbank institutions and consolidation of national
lending operations into Texas banks.
A credit crunch is not a necessary conse-
quence of an economic downturn. Lending declines
during an economic downturn, but primarily
because of decreases in business and consumer
loan demand. In Texas, however, the economic
climate has played an important role in the credit
Federal Reserve Bank of Dallas 4
crunch. A chain reaction of huge shocks to the
Texas economy resulted in the near destruction of
several key industries the state had relied on for
growth throughout the 1970s and 1980s. To
under-stand the Texas credit crunch, we must first
understand the nature of this abnormally strong
downturn and its repercussions on the economy.
In the late 1970s and early 1980s, the Texas
economy prospered as the oil and gas industry
boomed. Growth in the oil industry fostered
employment growth in all sectors of the Texas
economy. The climate was especially hospitable
for commercial real estate.
3
Low vacancy rates,
changes in tax laws, and financial deregulation in
the early 1980s motivated investment in commer-
cial real estate.
4
The state’s strong economy and a
drop in interest rates also encouraged the flow of
funds to the real estate sector (Petersen 1992). As
a result, office building permit values nearly
doubled from $1,143 million in 1980 to $2,184
million in 1985.
Even when an initial weakening of oil prices
in 1982 triggered a downturn in parts of the Texas
economy, commercial real estate activity continued.
Bankers’ and other investors’ interest in office
buildings persevered in the face of skyrocketing
vacancy rates. Office vacancy rates in major Texas
cities increased from 8 percent in 1980 to 24.3
percent in 1985, as office building permits con-
tinued to rise (Petersen 1992).
Texas was not so lucky after a second sharp
decline in oil prices in 1986. Recession struck the
state but not the nation. Texas is an oil-producing
state and an exporter of oil-field machinery, while
the nation is an oil importer. Reversals of the tax
laws that had favored commercial real estate
investments exacerbated the state’s economic
problems by accelerating the flow of funds out
of the office construction arena. The state lost
250,000 jobs and gained the burden of an extra-
ordinary amount of vacant office space. In 1987,
vacancy rates were near 30 percent in most major
Texas cities.
Unfortunately, the shocks engendering the
collapse of petroleum and construction were only
the beginning for Texas. Like other investors,
many aggressive banks were caught holding loans
to both oil and gas producers and commercial real
estate developers (Gunther 1989). Nonperforming
loan rates at Texas banks increased steadily from
1984 to 1987, and troubled assets caused declines in
equity capital and bank failures (Robinson 1990).
During the 1980s, equity capital at Texas
banks followed the same pattern as lending. From
1980 to 1985, equity capital increased by 85 per-
cent, or $6.2 billion. After the downturn in the
Texas economy, equity capital declined by 41 per-
cent, or $5.6 billion. The declines in equity capital
resulted from $10.8 billion in loan losses experi-
enced by Texas banks during the second half of
the 1980s.
5
Although equity capital improved
somewhat in 1989 and 1990, it was 23 percent
below its peak.
3
See Petersen (1992) for an excellent description of and
outlook for the Texas commercial real estate industry.
4
Petersen (1992) explains that the Economic Recovery Tax
Act of 1981 redefined the business depreciation allowance
for some real estate properties to allow for an accelerated
recovery of investments, thus making those investments
more attractive. For an extended discussion of the effects of
depreciation rates on real estate decisions, see Yeats
(1989). Also, the Depository Institutions Deregulation and
Monetary Control Act of 1980, which helped phase out
interest rate ceilings on time and savings deposits, and the
Garn–St Germain Depository Institution Act of 1982, which
created the money market deposit account, resulted in a
large source of new funds. The Garn–St Germain Act further
liberalized investments that S&Ls could make (although
Texas state-chartered S&Ls already had these powers) and
included provisions for the creation of nonexistent capital
through the issuance of capital certificates. Together, these
changes provided tremendous incentives favoring invest-
ment in commercial real estate.
5
When loans are charged off as losses, these losses are
deducted from the allowance for loan loss (a reserve
account on the balance sheet), which historically was
considered a part of regulatory capital. If the charge-offs
are large, then the allowance must be replenished be-
cause the adequacy of the allowance is judged relative
to the size of the loan portfolio and its risk. This is done by
increasing the provision for loan losses (an expense item on
the income statement). If this provision is large enough,
it can cause net income to be negative; in other words,
the bank sustains a net loss. If income is negative, then
the equity capital position is reduced by the amount of
the loss. Essentially, if the decline in the allowance for
loan loss is so large that it cannot be absorbed by current
income, then monies are diverted from equity capital to
the allowance for loan losses.
Economic Review—Third Quarter 1993 5
For many banks, the decline in bank capital
was fatal. Bank failures skyrocketed to levels not
seen since the Great Depression. No Texas banks
failed in 1981, but thirty-seven did in 1986, and
the numbers kept climbing.
6
Texas bank failures
peaked in 1988 at 149 and were down to 31 in
1992. The savings and loan industry suffered an
even higher failure rate.
Pathology of a credit crunch
Researchers at the Federal Reserve Bank of
Dallas have examined the connection between
financial health of banks and their lending activity
and have found that during the latter half of the
1980s, many Texas banks were too unhealthy to
lend. Financially unhealthy banks are those with
capital-asset ratios below 6 percent, with negative
income, or with a troubled-asset ratio of 3 percent
or more. In 1986, 55 percent of Texas banks
holding 72 percent of the state’s total banking
assets were unhealthy by this standard. Increased
lending by these banks would have exposed them
to unacceptable risk of failure. Lending would
have been discouraged or prohibited by bank
supervisors and, in all likelihood, by the banks’
own boards of directors.
Since the second quarter of 1988, the health
of the state’s banking industry has steadily im-
proved. By the fourth quarter of 1992, 72 percent
of Texas banks, with 82 percent of the state’s
assets, were healthy (Table 1). The improvement
resulted from the failure of many unhealthy banks,
from customers’ switching their business from
unhealthy banks to healthy banks, and the finan-
cial recovery of some unhealthy banks. However,
the fact that 304 unhealthy Texas banks were
holding approximately one-fifth of the state’s
assets as of the fourth quarter of 1992 indicates
the im-provement has been slow (Clair and Sigalla
1993).
The inability of healthy Texas banks to take
market share away from unhealthy banks in a
timely manner contributed to the slow recovery of
Texas banking. When banking problems escalated
Table 1
Texas Banking Statistics
(all figures are percentages)
1988 1989 1990 1991 1992
Healthy Bank Index
1
38.12 49.53 60.60 68.30 81.57
Return on Assets –1.21 –.33 .41 .65 1.07
Nonperforming Loan Ratio
2
6.41 6.59 3.14 2.85 1.70
Primary Capital Ratio
3
6.40 6.02 7.20 7.44 7.68
Growth Rate of Securities 10.42 10.95 18.66 14.65 3.67
Growth Rate of Loans –17.61 –7.43 –4.59 –2.53 6.69
1
This index is the percentage of assets held by healthy banks. A bank is defined as healthy if it is earning a profit, has a troubled
asset ratio below 3 percent, and has a capital ratio at least one-half percentage point above the regulatory minimum.
2
Nonperforming loans are all loans 90 days or more past due or nonaccruing divided by total loans.
3
Primary capital ratio is the sum of bank equity and loan loss reserves divided by the sum of total assets and loan loss reserves.
SOURCE: Federal Reserve Bank of Dallas.
6
Banks failures had slowly increased in the four years
preceding the oil and construction bust. Although no Texas
banks failed in 1981, five banks failed in both 1982 and
1983, six banks failed in 1984, and thirteen in 1985. This
slow but steady increase signaled the increasing fragility of
the banking industry before the economic shock.
Federal Reserve Bank of Dallas 6
in 1986, healthy banks were small compared with
their unhealthy competitors. The average healthy
bank had only $67 million in assets compared
with $136 million for unhealthy banks. Healthy
banks controlled only 28 percent of Texas bank-
ing assets. Thus, for healthy banks to take over
the market share of unhealthy banks would have
required an inconceivably rapid expansion.
The rate at which healthy banks can take
over the market share of unhealthy banks is
limited by healthy banks’ capital in excess of
regulatory minimums. Raising capital in the equity
markets was and is difficult for these healthy
banks. Their small size means small equity offer-
ings, which are costly to sell. Moreover, the chaotic
state of the Texas banking market caused investors
to shy away from Texas bank stocks. The only
alternative left open to banks was to raise capital
through the slow process of retaining earnings.
Even if the average-size healthy Texas bank
retained 75 percent of its earnings and maintained
its primary capital-to-asset ratio, individually it
could increase lending by only $2.4 million per
year. If all healthy banks followed the same strategy,
they could have only increased total lending by
$2 billion—only a 1.7-percent annual increase.
But not all healthy banks increased their
lending activity, which indicates an important
pathology. The term pathology applies in this case
because a bank in good financial condition in a
growing region would normally be expected to
increase its lending activity (Rosenblum 1991).
Those healthy banks not building their loan
portfolios represented a significant share of the
healthy banks in Texas. Of the 619 banks that
were healthy as of the first quarter of 1991 and
that had reported data for the past ten quarters,
nearly 40 percent did not increase their lending
from the first quarter of 1990 to the first quarter of
1991 (Rosenblum 1991). These banks accounted
for 40 percent of the assets and 35 percent of the
loans of healthy Texas banks at that time.
The pathology of financially healthy banks
in a growing state not increasing their lending
raises the need for an examination of the possible
causes. The extension of bank credit, especially to
small and mid-size businesses, supports new job
creation and economic expansion. The remainder
of this article discusses serious impediments
affecting the supply of credit.
Six causes of the credit crunch
Declines in bank capital
Business-cycle effects typically do not cause
a credit crunch. Business lending after adjusting
for inflation typically moves with the business
cycle with a lag. Both demand and supply shifts
contribute to the cyclical movement. During a
slowdown, demand for credit declines and the
supply of credit also contracts because loans
become riskier. After the recovery is established,
demand increases and banks begin lending again.
In an atypically severe cycle, the ability of
banks to begin lending after the recovery is estab-
lished may be hindered. During the recession
phase of a severe cycle, the larger than normal
loan losses result in larger than normal reductions
in bank capital and numerous bank failures. Loan
losses in the recent regional and national reces-
sions have been severe, especially when viewed
relative to bank capital. During the 1985–90 period,
banks in Texas made provisions for $14.5 billion
in loan losses, and their total capital at the end of
this period was $10.3 billion. Even among surviv-
ing banks, capital may fall below either the level
desired by bank management or the minimums
established by regulatory agencies. In either case,
the expansion of credit will be limited by the bank
capital levels (Clair and Yeats 1991, Hancock and
Wilcox 1992).
Not only did loan losses reduce bank capital,
but minimum capital standards rose. Baer and
McElravey (1993) have examined the factors
causing an increased demand for bank capital in
the two-year period beginning in June 1989. By
their estimates, meeting higher capital standards,
whether imposed by regulators or adopted by more
conservative bankers, had twice the effect of loan
losses in creating the need for new bank capital.
Bank capital standards rose substantially over
the 1980s and early 1990s (Baer and McElravey
1993). In the 1970s, bank supervisors set minimum
capital ratios for each bank, based on ratios at
similar banks. Bank capital ratios had been declin-
ing during the 1970s, and concerned regulators
established a minimum primary capital ratio of 5.5
percent in late 1981, to be phased in over time.
By the latter half of the 1980s, bank regula-
tors, as part of an international agreement, estab-
lished risk-based capital ratios. Regulators assign
Economic Review—Third Quarter 1993 7
risk weights to various types of assets and off-
balance-sheet risks and require capital to be held
in proportion to the credit risk of the bank port-
folio. For example, short-term Treasuries have a
zero credit risk weight, and business loans have a
100-percent risk weight.
Risk-based capital ratios may have raised the
relative cost of lending compared with investing
in securities. If these risk-based ratios are a bind-
ing constraint on banks, then increasing business
lending will require additional capital to be raised,
but investing in short-term Treasuries requires no
additional capital.
7
Since capital is costly, the risk-
based system increases the cost of business loans
relative to securities, thereby discouraging busi-
ness lending.
8
In addition to risk-based capital ratios, regula-
tors removed the primary capital ratio requirement
and replaced it with a leverage ratio requirement.
Whether the leverage ratio is a higher constraint is
uncertain. The required leverage ratio is dependent
on a bank’s risk rating. Nominally, a top-rated bank
could have a leverage ratio of 3 percent, but most
banks were expected to maintain leverage ratios
in the neighborhood of 4 percent to 5 percent.
9
The old primary capital ratio was 5.5 percent, but
it included loan loss reserves in the definition of
capital, which the new leverage ratio does not.
While a direct comparison of these new
capital regulations is not possible, an empirical
analysis by Baer and McElravey (1993) indicates
that banks are behaving as though their minimum
capital requirements have risen substantially over
the past few years. Based on their analysis, banks
now respond as though their required leverage
ratio has risen from 4 percent in the 1973–75
period to 7 percent in the 1989–91 period. Banks
are behaving as though they are setting internal
minimum capital standards much higher than the
regulatory minimums. The pressure on banks,
whether from regulators or internal management,
to maintain higher capital ratios has severely
limited their ability to extend new credit.
FDIC and RTC resolution of failed
depository institutions
While loan losses directly reduced capital,
the resolution of failed banks and thrifts increased
the demand for capital. After a depository institu-
tion fails, its assets are taken over by the deposit
insurer. Typically, the insurer sells the institution,
often after cleaning the portfolio of the nonper-
forming assets.
10
The acquiring institution must
have sufficient capital in excess of regulatory
minimums to be able to increase its total asset
holdings without becoming undercapitalized.
The resolution of failed banks and thrifts was
not the only source of assets to be acquired. Many
banks that did not fail but were undercapitalized
reduced their assets to improve their leverage ratios.
They had to sell these assets to healthier institu-
tions that had sufficient excess capital to purchase
the assets and remain sufficiently capitalized.
Baer and McElravey (1993) term this process
the recycling of assets, suggesting that assets are
recycled from undercapitalized to well-capitalized
banks and thrifts. During the two-year period
beginning June 1989, undercapitalized bank hold-
ing companies sold $82.8 billion in assets, failed
banks accounted for $58.6 billion, and failed thrifts
accounted for $177 billion, for a total $318.4 billion
in recycled assets. Recycling these assets increased
the need for capital by more than $22 billion, a
7
There is a requirement for a minimum leverage ratio that
requires a bank hold some capital regardless of the compo-
sition of its asset portfolio.
8
Risk-based capital is not a bad idea in theory. That riskier
institutions should hold greater capital is logical. If the loans
diversify the bank’s overall portfolio, however, then in-
creased lending may decrease a bank’s risk.
9
It is erroneous to think that a bank is permitted to operate
with a leverage ratio of 3 percent. There is a catch-22. Banks
are rated from one to five on the CAMEL scale, with one
being the highest rating possible. CAMEL is an acronym for
capital, asset quality, management, earnings, and liquidity.
A bank can’t get a CAMEL-one rating with only 3 percent
capital, but if the bank has a CAMEL-one rating, it is
permitted to have only 3 percent capital.
10
In some cases, the acquiring institution also acted as a
collecting bank for the Federal Deposit Insurance Corpora-
tion (FDIC). In these cases, it was common for the bank to
carry the assets in the collection operation under a special
classification of “other assets,” and the bank was not
required to hold capital against these assets. Since the
losses incurred from these collecting bank assets would be
borne by the FDIC, the bank did not need to hold capital
against these assets.
Federal Reserve Bank of Dallas 8
28.7-percent increase in capital at the time.
Beyond increasing the demand for capital by
recycling assets of failed institutions, the failure–
resolution process destroyed valuable informa-
tion—reducing the ability of many borrowers to
obtain credit (Board of Directors of the Federal
Reserve Bank of Dallas 1991). Effective lending
involves the ability of bankers to develop special-
ized information regarding their borrowers. This
information allows bankers to make informed
credit decisions at minimal cost. Anything that
disrupts the banker–borrower relationship can
lose or destroy the specialized information a
banker has about a specific borrower.
One type of this specialized information is
the banker’s assessment of the borrower’s character
—a signal of the borrower’s commitment to repay
a loan under adverse conditions. Bankers attempt
to assess the character of a borrower prior to
making a loan. This assessment is hard to quantify
or document and is an important judgment call
that a bank officer must make.
Many borrowers will face difficulty in repay-
ing during an economic downturn. Some will be
unwilling to accept any personal sacrifice and will
be quick to declare bankruptcy or otherwise force
a bank into losses. Other borrowers, those with
greater character, will make every reasonable
effort to repay their obligations and will make
personal sacrifices in the process.
During an economic downturn, the loan
documentation of borrowers with radically different
characters may appear very similar. The repayment
may appear poor—that is, late or partial pay-
ments or violated loan covenants. Bankers know
which borrowers are making tremendous efforts
to meet their obligations and which borrowers
expect the bank to be the first to forgo payment.
Both loans may be classified as nonperforming.
When a failed bank is resolved, nonperform-
ing loans are often either placed in a collecting
bank or are held by the FDIC for liquidation.
Borrowers must establish new banking relation-
ships. But being placed in these collecting or
liquidating operations places an equal stigma on
borrowers of good and poor character. Resolving
the failed bank destroyed the information that
distinguished low-risk from high-risk borrowers.
Being placed in a collecting bank can even
tarnish the reputation of borrowers with perfect
repayment records. In the late 1980s, regulators
created the “nonperforming performing” loan
category. These loans were current on payments
and not in violation of any loan covenants. Because
the examiners considered the loans unlikely to be
repaid given the examiners’ current economic
outlook, they classified them as nonperforming.
As a result, another group of borrowers may have
been inappropriately placed in the collecting bank
and thereby faced substantial damage to their
reputations.
The resolution of the failed banks and thrifts
was inevitable, and it improved the health of the
financial industry. The huge demand for capital
required to recycle assets was unavoidable. Still,
the increased demand for capital to fund these
assets limited the capital available to fund new
loans. The resolution process, however, destroyed
valuable information on borrower relationships,
and a reevaluation of the process to determine if
the negative economic impacts of closing failed
banks and thrifts can be reduced is warranted.
Bank supervision overreaction
The evidence that an overreaction by bank
supervisors caused the credit crunch is mixed.
Since the potential impact of bank examiners on
credit decisions is large, the evidence needs to be
presented. There are many different ways in
which bank examiners, in the process of enforcing
safety and soundness guidelines, might constrain
bank lending.
1. Examiners could criticize existing loans—
requiring banks to increase loan loss
provisions and charge-offs, and thus
reduce their capital.
2. Examiners could become more conserva-
tive in evaluating a bank’s condition and
thereby require a higher leverage ratio.
3. The specter of examiners’ criticism alone
could discourage loans from being
extended.
4. For more troubled institutions, examiners
may be directly setting restrictions on
lending activity
5. Higher loan documentation requirements
could raise costs, but these requirements
may be more directly related to the
regulatory burden and will be discussed
elsewhere.
Economic Review—Third Quarter 1993 9
Each of these supervisory and regulatory imposi-
tions will have different effects on bank financial
statements.
The hypothesis that bank examiner over-
reaction caused the credit crunch arises from the
February 1990 advisory sent by the Office of the
Comptroller of the Currency (OCC) to all banks
warning against making imprudent real estate
loans. In November 1990, as the national economy
weakened, the Bush administration blamed the
tight credit conditions on an overreaction by bank
supervisors. Most bankers responded, however,
that it had been and was the lack of loan demand
and deteriorating economic conditions that dis-
couraged their lending and not supervisory excess
(Owens and Schreft 1992).
The evidence indicates that bank examiners
did not overreact in criticizing existing loans and
requiring good loans to be charged off. Bernanke
and Lown (1991) examine this issue by analyzing
the trend of provisions for loan losses relative to
actual net charge-offs. Certainly, provisions for
loan losses and net charge-offs rose during the
1980s, but the ratio of provision to charge-offs
was very steady, indicating that examiners did not
raise the standard for provisioning excessively.
Accordingly, Bernanke and Lown conclude that
examiners have not suddenly imposed new tighter
examination standards that have constrained credit.
Even so, there is evidence that bank examin-
ers are enforcing a more conservative view of what
constitutes a healthy bank. David Bizer of the
Securities and Exchange Commission has argued
that bank examiners have raised the financial
standards for any given CAMEL rating (Bizer 1993).
This change to more conservative CAMEL
ratings is related to the credit crunch because the
required leverage ratio is tied to a bank’s CAMEL
rating. The minimum leverage ratio is set at 3
percent for banks rated CAMEL one and rises as
CAMEL ratings worsen. If bank examiners raise the
standards for any given CAMEL rating, they are, in
fact, increasing the minimum capital standard.
Bank examiners could also affect credit
decisions by raising the expected cost of funding
the credit. The cost of funds is a combination of the
cost of the necessary capital and the cost of deposit
funds. If bankers perceive, even erroneously, that
examiners might criticize new credit extensions,
then they expect that a larger share of new credits
will have to be funded with relatively expensive
capital, driving up the expected funding cost and
discouraging new lending. These concerns could
drive up funding costs by 70 basis points or more.
(For a detailed example of this effect, see the box
entitled “Examiners and Funding Costs.”)
It is possible that bank supervisors are con-
straining lending activity beyond their power to
set higher leverage ratios. Peek and Rosengren
(1993) analyzed new lending activity of banks in
New England, adjusting for whether a bank was
operating under a formal agreement with its primary
regulator. Regulators impose formal agreements
on banks considered seriously troubled or even
recalcitrant in repairing their financial condition.
Such agreements allow the regulator to seek civil
or even criminal penalties in the case of non-
compliance.
After controlling for differences in leverage
ratios, Rosengren and Peek’s results indicate that
new lending was significantly lower at banks
operating under formal agreements than at banks
with equally low capital ratios but not under such
agreements. They conclude that banks may be
slow to constrain their lending or to rebuild their
capital on their own. Once the formal agreement
is in place, however, banks respond much more
quickly.
In sum, regulators constrain credit growth at
weak institutions that are unwilling to temper
their own behavior when faced with declining
capital. But constraining the credit expansion of
weak institutions does not cause credit crunches.
In fact, it may prevent them in the future. Texas
had many institutions that lent freely despite their
weak financial condition. As a result, imprudent
loans were extended, especially in commercial
real estate development. The overbuilding that
ensued affected the value of collateral supporting
what otherwise would probably have been good
loans made by financially strong institutions.
During the worst of the Texas banking crisis,
managers of well-run banks called for bank super-
visors to shut down the activity of insolvent or
nearly insolvent institutions.
In conclusion, bank supervisors do not
appear to have required excessive charge-offs of
nonperforming loans. Supervisors did constrain
lending at financially weak institutions, but that is
the proper role of supervisors. Bankers’ concerns
Federal Reserve Bank of Dallas 10
that new loans might be criticized, however, may
have discouraged lending by raising the expected
cost of funding these loans.
New credit standards set by bankers
Atypically severe recessions alter both
bankers’ and bank supervisors’ perception of risk.
After an unusually severe recession and a sharp
increase in bank failures, bankers will likely re-
evaluate risk and change their risk-taking behavior,
require more capital to buffer against it, or both.
Their willingness to supply credit is likely reduced.
In hindsight, the old credit standards were
too lax.
11
If loans had been properly priced, banks
would have accumulated sufficient capital during
expansions to absorb loan losses during down-
Bank examiners can change the ex-
pected cost of funding a new loan by changing
the banker perception of what loans might be
criticized, which would change the required
mix of capital and deposits needed to fund the
loan. Loans are funded by a combination of
capital and deposits.
1
Baer and McElravey’s
(1993) results indicate that banks would want
a loan to be funded with 7 percent capital and
93 percent deposits. Capital is more costly to
raise than deposits. For the purposes of our
example here, it is assumed that capital re-
quires a 15-percent return, and deposits cost
3 percent. In this simple example, the funding
cost of a loan is the weighted average of these
two costs, 3.8 percent, or
(.07 × 15%) + (.93 × 3%).
If, however, bankers believe examiners
will criticize the loan, then the funding cost of
the loan will rise sharply. Suppose bankers
believe examiners will criticize the loan and
require 30 percent of the loan to be reserved.
In this case, approximately 65 percent of the
loan would be funded with deposits and 35
percent with capital (30 percent of the loan is
100 percent funded by capital by being re-
served and the remaining 70 percent of the
Examiners and Funding Costs
loan that still requires a 7-percent leverage
ratio.) In this case, the funding cost would rise
to 7.2 percent, or
{[.30 + (.70 × .07)] × 15%} + (.65 × 3%).
Now, if the banker believes there is only
a 20-percent probability that the loan will be
criticized, then the cost of funding would be
the weighted average of these two funding
costs, that is, 4.5 percent, or
(.20 × 7.2%) + (.80 × 3.8%).
Therefore, just the specter of examiner over-
reaction could increase the expected cost of
funding 70 basis points, from 3.8 percent to
4.5 percent. Given this expectation, many
loans would never be made. Beyond a lack of
lending, there would be no direct evidence of
this effect in bank financial statements, that is,
no sharp rise in provisions for loan losses or
charge-offs.
1
To be precise, loans are funded by capital and liabilities.
Liabilities include deposits in addition to federal funds pur-
chased, other debt instruments, etc. For the purposes of this
example, we have simplified the bank’s funding to capital and
deposits only.
11
Hindsight is always 20-20. For example, most cities will not
grant building permits for land within a 100-year flood plain.
If a new record flood results in the destruction of homes, it
could be said that the previous standard was too lax. Higher
standards would mean less risk, but the cost would be more
land that could not be used for buildings.
Economic Review—Third Quarter 1993 11
turns. This is not what happened in Texas. Many
banks failed because their reserves and capital
were insufficient to absorb loan losses. The
inability of banks to properly price risk is related
to the disincentives inherent in the deposit
insurance system (Short and O’Driscoll 1983).
Bankers have contracted the supply of credit
by raising credit standards and denying credit to
many borrowers. Some of the rejected applicants
have qualified for loans in the past or are even
current borrowers seeking credit extensions. This
change in status from creditworthy to uncredit-
worthy can be difficult to accept and can damage
borrowers’ businesses since many planned on
continued access to credit.
Probably the greatest difference between
borrowers’ and bankers’ perceptions is that
borrowers perceive creditworthiness as an indi-
vidual characteristic, while bankers view credit-
worthiness on both an individual basis and on the
basis of the entire portfolio of loans. To illustrate,
suppose that prior to a severe recession, a banker
expects a 2-percent loss rate on loans to a given
industry but during the recession, actually sustains a
5-percent loss rate. In response, the banker raises
the credit standards for borrowers in this industry
with the intention of obtaining a 2-percent loss
rate. The higher standards, however, might result
in, say, 25 percent of the previous borrowers
being unable to qualify for credit.
The majority of rejected borrowers will have
repaid their loans on time and in full. These
borrowers are not different—in either financial
characteristics or character—from the minority
that defaulted. The bank realizes that the likelihood
that an individual borrower will default is not
easily guessed but that the default rate for a port-
folio of loans is fairly predictable. The borrowers
see themselves as good bank customers—not as
the inadvertently lucky ones who did not default
—and do not understand why they have been
rejected. They complain, accordingly, that there is
a credit crunch.
Returning to the issue of real, rather than
hypothetical problems, the reevaluation of risk-
return tradeoffs during the 1980s in Texas was not
uniform across industries or types of loans. During
this regional recession, some industries proved far
riskier than bankers previously thought. In the
1980s, energy prices fell by more than 50 percent.
Real estate values plunged. Consequently, many
bankers revised their expectations for these indus-
tries more than for others.
Borrowers’ confusion over their own credit-
worthiness was compounded by banks that were
too weak financially to lend but pretended to
consider loans for approval. If a bank’s condition
deteriorates to the point that it is unable to extend
credit, the bank would likely want to conceal that
fact. Otherwise, depositors might demand higher
interest rates, and the bank’s best borrowers might
take their business elsewhere (Rosenblum 1991).
To create the appearance of financial health, the
bank pretends to continue its lending operations
—including marketing activities. Even high-quality
loan proposals are rejected, however, under the
pretense that they are too “risky.”
This masquerade is costly. The cost of
camouflaging is borne by the borrowers that waste
time and resources applying for loans from banks
that are incapable of lending. In addition, other
banks consider the rejection of the loan proposal
a sign that the proposal really is too risky. As a
result, with each rejection borrowers find it
increasingly difficult to locate a willing lender.
Regulatory burden
Banking has been and currently is one of
the most regulated industries in the United States.
In its report on the regulatory burden, the Federal
Financial Institutions Examination Council (1992)
stated, “Certainly federal regulation of banking is
pervasive in 1992; it affects virtually every aspect
of industry behavior.” The American Bankers
Association estimates that banks employ more than
75,000 people just to comply with regulations, an
average of more than six employees per bank.
The extent of the burden of regulation is
best summarized by the following quote on the
extension of just one type of credit (Greater
Cincinnati Business Record 1992):
Our biggest concern in the banking
industry is the overregulation. It’s unbelievable
the regulations that the bank has to live with. If
one of our people at one of our banking centers
at one of our branches wants to make a car loan
to you, here’s the legislation that they have to be
totally familiar with: the Consumer Credit Pro-
tection Act, the Truth in Lending Act, the Equal
Federal Reserve Bank of Dallas 12
Credit Opportunity Act, the Fair Credit and
Charge Card Disclosure Act, the Home Equity
Loan Consumer Protection Act of 1988, the Fair
Housing Act, the Real Estate Settlement Pro-
cedures Act, the Flood Insurance Protection Act,
the Fair Credit Billing Act, the Fair Credit Report-
ing Act, the Home Mortgage Disclosure Act, the
Fair Debt Collection Practice Act, the Consumer
Leasing Act, the Community Reinvestment Act,
the Bank Bribery Act, and the Securities and
Exchange Act....And this isn’t an inclusive listing.
It’s absolute insanity.
— George A. Schaefer, Jr.,
president and chief executive
officer, Fifth Third Bank.
There are costs and benefits to every regula-
tion. Consumer protection and antidiscrimination
laws are worthwhile goals. Achieving these goals
is costly, and one cost is the effect of regulatory
burden on the availability of credit. Judging
whether the costs outweigh the benefits of any
given regulation is outside the scope of this
article, which is presenting only an explanation of
some of the more hidden costs of regulation.
If banks have always faced a heavy regula-
tory burden, why is this now being proposed as a
source of the credit crunch? The credit crunch did
not begin until 1986 in Texas and even later else-
where in the nation. It is crucial then to focus on
what new regulations were enforced during this
period. In addition, the financial condition of the
banking industry should to be taken into account
when, the effect of additional regulation is assessed.
Following the failures of banks and thrifts,
Congress passed three major banking bills that
increased the regulatory micromanagement of
banks: the Competitive Equality Banking Act of
1987; the Financial Institutions Reform, Recovery,
and Enforcement Act of 1989 (FIRREA); and the
Federal Deposit Insurance Corporation Improve-
ment Act of 1991 (FDICIA). These statutes funded
the closure of insolvent thrifts and constrained
banking activity.
Consumer protection laws also have in-
creased sharply, with seven new laws since 1985
(Spong 1990). In addition, enforcement of some
previously passed legislation increased suddenly in
the early 1980s. By many accounts, the Commu-
nity Reinvestment Act of 1977 (CRA) caused bankers
relatively little concern until 1989, when a major
bank’s application for an acquisition was denied
because it failed to meet its CRA responsibilities.
The increased regulatory burden further
extended the time needed for healthy banks to
take over the market share of unhealthy banks and
for unhealthy banks to recover. The additional
costs imposed on banks lowered their net income,
slowing the rebuilding of capital through retained
earnings. If the capital losses of the 1980s created
a credit crunch, then the increased regulatory
burden extended its life.
12
The regulatory burden’s impact on the credit
crunch is directly related to increased compliance
costs. Four different estimates of the compliance
cost are presented in Table 2 and range from $7.5
billion to $17 billion for 1992. Based on the lowest
estimate of $7.5 billion, if these funds could have
been applied to capital rebuilding, banks could
have funded an asset expansion of $93 billion
(assuming an 8-percent capital-to-asset ratio). This
analysis, however, has not attempted to measure
the benefits of regulation.
The regulatory burden not only contributed
to the credit crunch by imposing a cost on banks,
but it also discouraged lending by imposing rela-
tively higher costs on lending than on investing
in securities. Most discussions of the cost of the
regulatory burden treat the cost as a lump-sum tax
that must be paid by the bank. A lump-sum cost
would not affect the banks’ decisions to lend
relative to invest in securities.
In reality, many regulatory requirements
impose a greater burden on lending than on
investing in securities. For example, regulatory
requirements for frequent appraisals on real estate
loans impose a cost on a type of loan that is not
imposed on securities. If compliance costs are
directly related to lending, then the regulatory
12
If the regulatory burden had been imposed on a healthy,
thriving banking industry, then it still would have had a
negative effect on lending. The effect might not have
been as noticeable. It might have been the difference
between slower credit growth instead of credit contrac-
tion. In either case, the effect of the regulatory burden
might be equal, but in a healthy banking industry it would
be offset by capital growth.
Economic Review—Third Quarter 1993 13
burden will discourage lending even after the
banks have replenished their capital.
A third way that regulation might reduce
lending is through mandates for direct credit
allocation. Through the CRA, Congress has sent a
message to banks and bank regulators that it wants
increased lending in lower income neighborhoods.
If banks are required to lend more to lower
income borrowers, then they will reduce their
lending to other borrowers (Gruben, Neuberger,
and Schmidt 1990), and they may reduce their
total lending and increase investment in Treasury
securities (Wood 1991). Borrowers from higher
income areas could perceive this shift as a con-
straint on credit availability.
13
This analysis is based on the following
assumptions:
1. that banks are judged for CRA compliance
by the percentage of their loan portfolio
that is lent in lower income areas;
14
2. that bankers are adverse to taking risk;
and
3. that bankers believe loans in lower
income neighborhoods are riskier than
loans in higher income neighborhoods.
If the cost of failing to comply with CRA is sub-
stantial, then banks will raise the proportion of
lower income loans in their loan portfolio. As
banks hold more of the riskiest assets, bankers
balance their portfolio’s risk exposure by investing
more in risk-free Treasury securities, and total
lending declines. In an extreme case, banks may
even decrease their loan portfolios so much that
the lower income group receives fewer total loans
than previously, even though their proportion of
the loan portfolio has risen.
Consequently, the enforcement of CRA, while
achieving certain goals, is an example of how
regulatory burden can reduce total lending through
three different mechanisms. First, by imposing
compliance costs, such as those for record keep-
ing, regulation can reduce net income and slow
Table 2
Cost of Regulatory Burden
Estimated annual costs for Cost as a percent on
Group conducting the study 1992 (billions of dollars) noninterest expenses
1
FFIEC
2
7.5 to 17 6% to 14%
ABA
3
10.7 10%
McKinsey 10.4* 8.1%
IBAA
4
Grant Thorton 11.1 8.7%
*Estimated value based on 1992 total noninterest expense of $128 billion.
1
Costs do not include the opportunity cost of holding required reserves that are not bearing interest.
2
Federal Financial Institutions Examination Council (FFIEC).
3
American Bankers Association (ABA) estimate does not include the cost of deposit insurance premiums, which could raise their
ratio by 5.3 percentage points based on the McKinsey & Co. study, and does not include the costs of FDICIA, which McKinsey &
Co. estimates to be at least 1.5 percentage points.
4
Independent Bankers Association of America (IBAA).
SOURCES: FFIEC; ABA; McKinsey & Co., Inc.; and IBAA.
13
The reduction in lending to other borrowers would be
especially severe if banks are operating at the minimum
acceptable levels of capital. If banks had excess capital,
then increased mandated lending to one group of borrow-
ers might not affect credit availability to other borrowers.
14
Currently, banks’ CRA compliance is judged on the basis of
making a good faith effort to serve the credit needs of low-
income communities within their markets.
Federal Reserve Bank of Dallas 14
the rebuilding of capital. Second, by imposing
costs on lending, such as those for geographic
loan coding, that are not imposed on investing,
regulation can discourage lending and encourage
investment in securities. Third, the direct alloca-
tion of loan portfolio shares into loans that are
perceived to be riskier can lead banks to balance
their overall risk by reducing total lending.
Cost of increased legal exposure
Lender liability lawsuits. Lender liability is a
growing concern and an important risk exposure
for banks. Bankers’ increasing concern over these
issues can be demonstrated by the rise in the
number of citations of “lender liability” in the
American Banker over the past seven years
(Figure 1). The sharp rise in citations that began
in 1986 is a clear indicator of bankers’ interest
and concern. The timing of the increase is likely
related to a 1985 case on wrongful termination of
credit.
One of the biggest legal problems for banks
is that uncertainty in the law makes it difficult to
determine what actions create liability. Uncertainty
raises the risk of extending loans, because banks
are unable to estimate their exposure to lawsuits.
Increased risk discourages lending and exacerbates
problems in credit availability.
A major area of concern for bankers is poten-
tial liability for environmental cleanup costs of
property belonging to the banks’ borrowers. Banks’
environmental liability arises from several sources
—the Comprehensive Environmental Response,
Compensation and Liability Act of 1980 (CERCLA,
or the Superfund law), the Resources Conserva-
tion Recovery Act (RCRA), and other state and
federal environmental laws.
Banking environmental litigation often con-
cerns CERCLA provisions that make owners or
operators of contaminated properties responsible
for environmental cleanup, even if they did not
cause the contamination. CERCLA contains an
exemption for creditors that take ownership in a
foreclosure (Scranton 1992). An interpretation by
the courts, however, left banks susceptible to
liability for conducting ordinary banking activities
(Garsson and Kleege 1991).
Bankers objected to this interpretation, which
made foreclosures especially risky. A bank impli-
cated under CERCLA faces liability for claims
limited only by the total cost of the cleanup,
possibly billions of dollars. The size of the bank’s
loan to the owner or operator of the contaminated
property does not limit the bank’s total exposure
to claims (Kleege 1992). The Environmental Pro-
tection Agency (EPA) has settled with banks for
smaller amounts, but as American Bankers Associa-
tion associate counsel Thomas J. Greco notes, “If
a bank hasn’t done anything, why should it be
paying anything at all?” (Kleege 1991a).
Some relief has been given. The EPA has
written new rules that define the terms when a
bank is liable for cleanup costs. These new rules,
however, have not been fully challenged in the
courts, and attempts to make the rules into law
have been unsuccessful in Congress.
Requiring banks to pay for property contami-
nation cleanup expenses has contributed to the
credit crunch. The cost of screening loans for
environmental risks discourages lending. Banks shy
away from extending loans to businesses that utilize
hazardous materials. Many of these businesses are
small, local businesses such as dry cleaners, funeral
parlors, gasoline stations, and farms (Garsson and
Kleege 1991). Knowledge or fears about environ-
mental liability can halt loans to businesses of any
kind, if bankers have reason to suspect contami-
nation (Kleege 1990). Beyond legal liability, the
Figure 1
Number of Articles on “Lender Liability”
in the American Banker
0
10
20
30
40
50
1992 1991 1990 1989 1988 1987 1986 1985
SOURCE: Federal Reserve Bank of Dallas.
Economic Review—Third Quarter 1993 15
bank is not protected from the borrower reducing
the value of the collateral through pollution.
Environmental issues are not the only ones
that can land banks in court. Banks face legal
liability in providing many banking services. With
regard to their borrowers, banks can be sued if
they exercise excessive control over borrowers or
if they wrongfully terminate credit. In addition,
banks can be sued under the Racketeer-Influenced
and Corrupt Organizations Act of 1970, also known
as the RICO Act, which was originally designed to
attack organized crime.
The issue of excessive control dates to a 1984
Texas court decision that established limits as to
what direct influence a bank can exert over its
borrowers. The effect of this decision is best sum-
marized by A. Barry Cappello, a lawyer specializ-
ing in lender liability, who said, “Whenever a
lender has anything other than an arm’s-length
relationship with its borrower, the potential for
liability exists” (Adkins 1992).
This decision has discouraged lending in at
least two ways. First, lending is now riskier because
banks are more limited in the actions they can
take to enhance the probability of repayment and
protect their collateral. Second, the cost of defend-
ing against such suits and the possible damages
that must be paid are costs to supplying credit
and must be factored in the bank’s pricing. As a
result, the amount of credit a bank is willing to
supply at any given price is reduced.
Legal exposure for the wrongful termination
of credit was a problem for banks in the mid-1980s,
but it has diminished in recent years. Court rulings
had made it no longer sufficient merely to stay
within the terms of the loan agreement; banks had
to show reasonable cause. In recent years, how-
ever, the courts have allowed banks to enforce
the terms of a loan agreement without imposing
additional requirements. The timing here is impor-
tant. Even if this legal issue has diminished in
importance in recent years, it could have contrib-
uted to the Texas credit crunch that began in 1985.
Though the RICO Act was passed in 1970, it
did not become a problem for bankers until 1985,
when the Supreme Court expanded RICO to
include banks. The RICO designation permits the
plaintiff to ask for treble damages. RICO is yet
another example of an increase in lender liability
that occurred in the mid-1980s. Protecting against
such lawsuits is costly and discourages lending. In
contrast, no one has ever been sued by the federal
government for buying Treasury securities.
Regulator lawsuits. In the 1980s, financial insti-
tutions failed for a variety of reasons, only some
of which might be considered criminal. Some
thrift and bank managers were guilty of criminal
misconduct because of insider dealing or other
fraudulent acts. Many other banks and thrifts
failed because they made mistakes in their loan
decisions. Often these mistakes were only apparent
after the fact and could not necessarily have been
foreseen at the time the loan was approved.
The FDIC, however, has reacted to the bank
failures with scores of lawsuits against bank officers
and directors. These lawsuits serve two purposes
for the FDIC. First, the lawsuits seek to collect on
the director and officer insurance banks routinely
purchase, shifting a portion of the costs to the
private insurance industry. Second, these lawsuits
tend to focus attention on the industry’s responsi-
bility for the problems.
In the 1990s, the FDIC has attempted to raise
the acceptable standard for bank officers’ and
directors’ behavior. Under the proposed standard,
a bank failure in the normal course of business
would be evidence of simple negligence, and the
FDIC would sue for damages. The courts have
failed to accept this new standard (Rehm 1993).
These lawsuits contribute to the credit crunch.
Bank officers and directors are encouraged to be
more cautious in assessing risk and return trade-
offs. Directors and officers are expected to avoid
ex post any risk that resulted in a loss to the bank.
Of course, the best way for a bank to avoid risk is
to avoid lending, an inherently risky activity.
These lawsuits also increase the difficulty of
recruiting highly competent individuals for posi-
tions on banks’ boards of directors. High-quality
directors monitoring bank management reduces
regulators’ burden monitoring the industry.
Furthermore, these lawsuits have resulted in
higher premiums for directors’ and officers’
insurance for nearly all banks. These higher
costs must be factored into loan pricing.
Conclusion
Sometimes, six observers can find six different
causes for a single problem, and they can all be
Federal Reserve Bank of Dallas 16
right. The credit crunch is an example. The credit
crunch is the result of multiple factors adversely
affecting banks’ ability to supply credit at a time
when banks’ ability to adjust to these factors was
unusually limited.
Increased lending is limited to some degree
by the necessary rebuilding of banks’ capital
positions. The drains on capital in recent years
have been substantial. Loan losses have directly
reduced capital at the banks experiencing the
loss; recycling the assets of failed banks and thrifts
also created a huge need for additional capital;
and following an atypically severe economic
contraction, both regulators and bankers appear
to have raised the acceptable minimum capital
levels and credit standards.
The costs of lending have also risen substan-
tially over this time period. The resolution of
failed banks and thrifts destroyed valuable infor-
mation. The perception of an overreaction by
bank examiners has raised the expected cost of
funding lending activity. Regulatory burden and
increased exposure to legal liability has raised the
cost of doing business for banks. By decreasing
net income, these costs compound the problem of
raising capital through retained earnings, and in
many cases, these costs skew the cost of extend-
ing loans relative to investing in securities.
Since there are multiple causes of the credit
crunch, the solutions to the credit crunch need to
be multifaceted. Some causes are temporary in
nature and will correct themselves over time.
Other causes, however, are structural and will not
be eliminated with economic recovery. Some
causes are the unintended side effects of policies
addressing other societal problems. Simply address-
ing the financial condition of the banks is unlikely
to generate a quick solution. Many healthy banks
in Texas have declined to increase their lending
in the first five years of the regional economic
expansion. While it is beyond the scope of this
article to propose solutions, solutions need to be
found. Many of the causes of the credit crunch are
the result of policies addressing other problems,
such as bank failures, community development,
credit discrimination, and access to the courts.
The positive outcome of these policies must be
carefully weighed against the economic conse-
quences of inhibiting the flow of credit and slow-
ing economic growth and job creation.
Economic Review—Third Quarter 1993 17
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