As I write this column, it is not certain who our next president will be. But one thing is certain: as president-elect Gore or Bush puts together his economic team, he should pay heed to how that team is qualified to deal with the upcoming banking crisis.
“What?” you protest. “Isn’t the economy doing great? Aren’t banks turning in record profits?”
In addition, you might point out, the United States is not Mexico, where incumbents cynically pump up the economy to secure the election of their anointed successors knowing full well that the economy will crash shortly after the election.
But financial history and some worrisome indicators warn us that many banks will face rough sledding in the foreseeable future. That need not have disastrous effects on the economy as a whole, but the extent and severity of eventual impacts will depend largely how the federal government responds–or fails to respond–to early warning signals.
Opinion is divided on the thinness the ice is under some U.S. banks. The October 21 issue of The Economist, the respected British weekly newsmagazine, lays out the pessimists’ position in a lengthy article. Banks have rising numbers of problem loans, even as the overall economy is as strong as it has ever been. Some banks are piling up risky loans in their portfolios because more credit-worthy borrowers can go directly to capital markets, bypassing the banking sector altogether.
Finally, some banks, largely based in Europe, have concentrated much of their lending in one sector–telecommunications–which is under increasing stress after a multi-year spending spree.
How widely shared are these concerns? The Economist article is based largely on the views of one analyst at the U.S. Office of the Comptroller of the Currency, which regulates most large national banks, together with those of a few private-sector banking analysts.
They are not alone, however. In the past year, Fed Chair Alan Greenspan repeatedly has warned about bankers’ propensity for making ever-riskier loans. And in an October federal report shows a drastic fall in the quality of large business loans that are shared among several banks. Problem loans in this category totaled over $100 billion. Nearly two-thirds of these were in the worst “classified” category. That total was up 70 percent from a year earlier and nearly three times what it was in 1998.
Moreover, an increasing number of large banks are disclosing losses in venture capital lending, with Chase alone recently writing down nearly half a billion dollars of such losses.
Why do banks get themselves into such hot water when an economy is booming? The simple answer is that bankers are human. The memories of periods of severe loan losses dim with time. Optimism about new lending opportunities or the new economy is infectious. Lenders overestimate their ability to manage risks.
Incentives are strong and unfortunately asymmetrical. Large banks are publicly held corporations. Corporate stockholders want competitive returns on their investment. Very cautious lenders have lower short-term profits than banks that do take on greater risk and hence greater short-term reward.
Competitive pressures, including a business environment in which “poor performers” get gobbled up by more profitable ones, provide incentives for bank managers to take on more risk than is wise from a long-term perspective for the bank itself or for society as a whole.
As in the savings and loan episode of our recent history, resources get funneled into physical and financial investments with progressively smaller returns for society, which, after the fact, may turn out to be negative. Some managers and stockholders may have qualms, but many assume that they can bail out while the bailing is good.
What can government do about this looming problem of severe bank losses? If the savings and loan crisis taught us anything, it must be to nip problems in the bud. Politicians and regulators are always tempted by the vain hope that more time will turn things around.
This seldom happens. Congress and the Reagan administration let the savings and loan abscess fester for years. What might have been solved with $20 billion or so of bailout funds if action had been taken in the mid-1980s eventually cost U.S. taxpayers more than 10 times that.
Japanese regulators have wasted a decade in similar vain hopes. The cost in terms of stagnation and lost output for that country is huge. The U.S. economy, though slowing, is still fundamentally strong.
This is not a time for regulatory forbearance. Congress and the new president should encourage regulators to be tough with banks by insisting on loan write-downs when necessary, regardless of what happens to the banks’ stock prices.
Delaying action until we are in a recession will only compound the problem.
© 2000 Edward Lotterman
Chanarambie Consulting, Inc.