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May 23, 2000

Smaller Banks to Get Closer Fed Scrutiny Over Riskier Loans
Dow Jones Newswires

Finally, the Fed Steps in...Weiss comments

WASHINGTON -- Federal Reserve Vice Chairman Roger Ferguson said Monday the Fed is increasing its surveillance of smaller banks with high concentrations of commercial and construction loans -- lending that may present potential trouble should the economy slow down.

"The late 1980s and early 1990s are a vivid illustration of the perils of weakening underwriting standards and credit concentrations. I should note that despite these lessons, many community banks have been expanding commercial real-estate and construction lending as never before," Ferguson said in prepared remarks to be delivered before the Independent Community Bankers of America. His text didn't mention monetary policy or the economic outlook.

"Commercial real-estate markets appear to be healthy now, but they are cyclical in nature and therefore must be approached with caution," he said.

Ferguson said small banks, those with $1 billion or less in assets, held about 12% of those assets in commercial real-estate and construction loans in 1990. That has since risen to about 17%. "As a supervisory response, we are stepping up oversight of those individual institutions that have higher concentrations of commercial and construction loans, especially in markets in which growth has been particularly strong and those in which vacancy rates appear to be rising," he said.

Banks have had an incentive to go after riskier loans because of fierce competition, Ferguson said. But they should be wary of the profits made on higher risk, higher return ventures.

"To the extent bank managements are not evaluating their income on a risk-adjusted basis, they are deluding themselves and their boards into thinking that profits are improving, when, in fact, greater embedded losses may be growing beneath the surface of ostensibly sound loan portfolios," he said.

Ferguson also used the occasion to remind bankers to be wary of interest-rate risk. Small banks are seen as more vulnerable to getting profits get squeezed when interest rates move higher because they have less fee income than larger banks. Higher rates mean a narrowing spread between what the banks can charge borrowers and what they have to pay to deposit holders. Such interest-rate risk is also affected by the maturity of assets a bank has, with the longer the maturity the riskier.

"There appears to be a marked change in attitude regarding interest-rate risk," Ferguson said, noting that the portion of bank assets maturing in five or more years has increased from 12% in 1990 to more than 20% at the end of 1999.

It's about time the Fed listen to us. We've been telling our subscribers about this problem for months. Lending by smaller banks has gone unfettered for far too long. Banks have extended a slew of new commercial and construction loans to risky parties.

In a period of rising interest rates, it is questionable whether these banks have taken into consideration higher borrowing costs and a higher risk of loan default when giving out these loans.

But, just sounding a warning to smaller banks is not going to solve this potentially dangerous problem. The Fed must act to tighten lending standards and become more hard line in enforcing the current lending standards.

In a bear market, which is what we are fast approaching, bad lending practices can push the economy into a heap of trouble. It is crucial that the Fed not just preach better lending practices, but act aggressively.