Unwise Lending Proves to Be the Culprit in Most Bank Failures

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AT INDUSTRY CONFERENCES, cocktail parties, and dinners, the question most frequently addressed to the chief executive officer of a bank is, "Why do banks fail?" Since this appears to be an issue of broiad interest, I thought I would provide our clients, friends, and shareholders with an outline of our views regarding the reasons for the numerous recent failures among banks and savings and loans.

The banking business is a fairly simple one. We take customer A's money as a custodian prepared to return it to him on demand or according to agreement, and we lend it to customer B, who covenants to return it to us on demand or according to agreement. Customer A is paid a lower rate of interest than is charged customer B. From that differential or "spread," we pay our costs of operations and deliver a profit to our shareholders.

The key to a successful banking business lies in the precautions taken to assure that the loan to customer B is underwritten properly so that it is repaid. This is true whether customer B is a partner in a San Francisco law firm, the owner of a mid-sized business, or Brazil. Banks fail because they make bad loans.

How bad is it?

* Last year, 120 banks closed, compared to fewer than 50 in 1983 and only 10 in 1981.

* An Arthur Andersen & Co. study estimates that the number of U.S. banks will drop from the 14,000 presently operating to 9,500 by 1990, a decrease of 32%.

* Bank regulators have put more than 800 of the nation's banks on their "problem bank" list. The list includes some of the country's largest money center banks.

Analyses by regulators reveal that loans to which bank failures can be attributed fall into four categories:

Insider Loans: Loans to officers, directors, and affiliates that are improperly underwritten due to the "friendly" relationship. In my opinion, these activities constitute fraud and are unforgivable.

Petrodollar-generated overlending: The energy price increase caused the revenues of smaller, petroleum-exporting nations to rise dramatically in the late 1970s. Major banks, recipients of these "petrodollars," were forced by the influx of new, costly deposits to seek loans aggressively.

This aggressive posture, fed by the deposit influx, led to the granting of large, unsecured loans to lesser-developed countries with no discernible means of repayment, under the "sovereign credit" theory that a nation cannot become bankrupt, and led to participation in lending schemes propounded by unqualified, poorly managed institutions whose sole reason for existence was their location in the "oil patch" (e.g., Penn Square Bank in Oklahoma).

According to Time, "problem foreign loans represents a disturbing 157% of the major banks' capital."

Deregulation/recession-generated bad loans: Deregulation of financial institutions, started in the mid-1970s, allowed banks and savings and loans to engage in areas of business from which they had previously been excluded and in which they were poorly prepared to participate (e.g., the newly granted authority for savings and loans to make commercial loans and equity investments).

Deregulation, which included the elimination or reduction of restrictions on interest paid on deposits, allowed banks and savings institutions to compete aggressively for deposits based on price. Free competition, with federal insurance of depositors' money up to $100,000, allowed institutions access to virtually unlimited funds. This influx of purchased funds made growth easily accessible as long as the increase in deposits (liabilities) could be matched with earning assets (loans). …