Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Were Bank Examiners Too Strict with New England and Californ

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Were Bank Examiners Too Strict with New England and Californ

Article excerpt

Massachusetts Gov. Michael Dukakis accused the Comptroller of the Currency of "enforcing stricter standards in New England than in the rest of the country."...New England's elected officials are...concern[ed] that regulators are pushing their once vibrant region into a recession by forcing banks to increase loan reserves [emphasis added], which, in turn, is causing them to tighten credit standards.

[T]here is widespread concern that the medicine might be worse than the disease. Bankers fear that regulators who were heavily criticized for not acting quickly when Texas banks were collapsing are now overreacting in New England.

In a reprise of the kind of regulatory crackdown already experienced in the East, California bankers report that federal agencies...have been harsh this year.

American Banker

During the early 1990s bank examiners were frequently accused of being too strict with banks in New England, thereby contributing to a credit crunch in the region.(1) If supervisors of New England banks were being unusually strict, they may have been reacting to public complaints of lax supervision of the savings and loan industry in the 1980s. Such complaints were rife as New England banks' loan problems were surfacing. As California's economy began a slowdown and banks there began to experience significant loan losses, examiners of California banks also were accused of being too strict. Unusually strict examination practices could have contributed to the large declines in bank loans and the severity of the economic downturns in New England and California.(2) Several studies have found evidence that the large declines in bank lending in New England were, in part, the result of constraints on bank lending imposed by regulatory capital standards (Peek and Rosengren 1992, 1993; Bernanke and Lown 1991).(3) These studies focus on whether capital constraints faced by New England banks during that region's economic troubles produced declines in bank lending. The capital constraints in many cases resulted from large additions to reserves for loan losses. The studies make no attempt to determine if bank examiners were inappropriately strict in the amount of additions to reserves for loan losses they required of banks, though Bernanke and Lown (1991) do briefly examine supervisory strictness and conclude that New England banks were not subject to overzealous supervision.

This article looks for evidence of excessive examiner strictness as manifested in the amount of reserves for loan losses New England and California banks were required to maintain. Here, strictness refers to the required level of reserves for loan losses relative to expected loan losses. While requiring banks to maintain a certain level of reserves for loan losses is only one of several ways examiner strictness can manifest itself, it is one of the most important. Allowing banks to hold reserves for loan losses that are too small relative to expected future losses, or, equivalently, allowing them to overvalue their loan portfolios, may increase bank failure costs borne by the deposit insurance fund. On the other hand, excessive strictness may lead to unnecessary cutbacks in bank lending. Such indeed is the contention of those criticizing examiners of New England and California banks. To test for loan loss reserve account strictness, we compare the ratio of reserves for loan losses to nonperforming loans for New England and California banks to the average ratio for all U.S. banks. If examiners were being unusually strict in the amount of loan loss reserves they required of New England and California banks, the ratio for these banks should have exceeded that of the average U.S. bank at the time of the hypothesized strictness. We also examine how the average ratio for New England and California banks changed in the periods before and during the hypothesized strictness. If examiners were unusually strict, the ratios for these banks should have increased to unusually high levels compared with past years. …

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