SYNOPSIS: Bush 1's bank reform plan does not address te difficult issues

Another Costly Financial Debacle? The Bush administration's plan, which promises to give banks new freedom to increase profitability, will not solve the financial crisis that currently plagues this country. In fact, if the bank crisis is further mishandled, it could eventually prove as costly as the recent S&L fiasco.

The most immediate problem is that the assets of many major U.S. banks are worth less than their liabilities. Banks are very highly "leveraged." That means their stockholders put up only a relatively small amount of money, while most of the funds they lend come from depositors. As a result, even modest loan losses can wipe out bank stockholders' equity. And major banks now face the prospect of substantial losses from real-estate loans, lending to Third World countries and loans for corporate takeovers and leveraged buyouts.

Deteriorating Loan Performance. Consider Citicorp. On paper, it has $ 230 billion in assets. These assets were bought overwhelmingly with depositors' money or with borrowed funds; the equity contributed by common stockholders was just over $ 8 billion. Of the assets, $ 17 billion represents claims on Third World countries, almost $ 16 billion is in loans backed by commercial real estate, and nearly $ 8 billion is in loans associated with highly leveraged corporate transactions. These are all fairly bad risks. Secondary prices of Third World debt -- loans sold by the lender to other investors -- have averaged only about 35 cents on the dollar. Plunging real-estate prices have dragged the value of property loans down with them. And loans to companies with heavy debt are trading at well below face value. Even a conservative estimate of the combined losses on these loans suggests that Citicorp stockholders' equity has been wiped out.

The market value of Citicorp stock, though it has fallen sharply, is still $ 4.6 billion. Cynical insiders suggest, however, that this number merely represents the hidden value of federal guarantees, which put a floor on possible losses without putting any ceiling on possible gains. More revealing are the rates that Citicorp has had to pay for recent borrowing: 13 percent or more, an indication that the market views the bank's debt like high-yielding junk bonds.

Citicorp's problems, which are especially severe but not unique, would have been unthinkable 15 years ago. Until the 1980s, banks rarely got in serious trouble because government regulation virtually insured their profitability. For example, banks had a monopoly when it came to offering checking accounts. Since consumers received no interest payments from these deposits, the banks in effect borrowed money for free and then loaned it out at big profits. This cushion is now gone, and the banks are vulnerable.

Bank Freedom Isn't Healthy. The Bush bank reform package needs to be examined with this in mind. The most meaningful part of the proposal would allow banks to undertake such new activities as interstate branching and investment in equities. This freedom is supposed to increase profitability and restore the banking system's health. Yet that is unlikely. Some savings may result as financial institutions merge and reduce overhead. But banks won't generate big profits by entering competitive new areas in which they are inexperienced. And providing banks with the opportunity to take additional risks raises chilling financial possibilities.

A similar approach to deregulation helped trigger the S&L industry's losses during the 1980s.

To avoid this danger, banks must be required to raise more capital and put enough stockholder money at risk so that they will have little incentive to engage in irresponsible investment. The Bush proposal fails to realize that historical norms for bank capital, developed when regulated banks were guaranteed moneymakers, are inadequate today. The problem, of course, is that forcing shaky banks to increase their capital may well result in their failure. This is the real dilemma of bank reform; it is one that the Bush administration has been unwilling to face.

Ailing Assets

Like other big banks, Citicorp has many high-risk loans.

Checkbook Contraction

The dramatic drop-off in U.S. noninterest-bearing checking accounts has bled bank profits.

Risky Real Estate

U.S. bank real-estate exposure grew dramatically during the late 1980's. Many of these loans have gone sour.

Originally published, 3.4.91