Banks on the Brink

America's banks are in trouble. Many of the largest and most powerful banks have been on a five-year expansion binge, spurred by bankers convinced that bigger is better. In their pursuit of growth, they have jeopardized the safety of your money, not to mention the survival of the entire banking system. Americans, accustomed to entrusting their money to banks without the slightest worry, should begin to worry--now.

Could we see a repeat of the Thirties, when thousands of banks were forced to close their doors, causing financial ruin for millions of depositors? It is quite possible that we will survive today's problems (continued on page 132) Banks on the Brink (continued from page 85) without catastrophe. But the situation bears a chilling resemblance to the Thirties, although outside forces, not the imprudent actions of bankers, brought on disaster then.

This was the chain of events in the Thirties: First, the stock market crashed in 1929; second, in 1931, a major European bank collapsed, plunging Europe into a financial crisis; third, within two years, the United States, along with the rest of the world, was in the grip of the Great Depression. By 1933, Roosevelt was forced to close every American bank, with only the healthy ones allowed to reopen. If your money was in any of the thousands of insolvent banks that remained padlocked, you were simply out of luck. The subsequent creation of a strong system of bank regulation and deposit insurance has convinced Americans that it could not happen again. This has been true for the past 40 years, but today's situation is different. You should know what has changed and what the risks are.

There are many ominous similarities between the events of the Thirties and what is happening now. You may not realize it, but the stock market has already crashed. During the five years up to October 1974, the decline in value of all publicly traded stocks has exceeded that of the 1929--1933 debacle, both in dollars and in percentage of drop--after adjusting for inflation. In Europe, the financial situation is rapidly approaching the crisis stage. Numerous small British banks have failed and, this past spring, the Bankhaus Herstatt of Germany collapsed, leaving unsatisfied claims of nearly one billion dollars. Bank Credit Analyst, which has monitored the banking world since 1949, recently stated: "In the first seven months of 1974, the banking structure of [Europe] has undergone an upheaval not seen since the banking crisis of the Thirties." In the Thirties, it took two years for Europe's fiscal downfall to reach America; today it would take about 24 hours.

We've had no world-wide depression--at least not yet. But many responsible observers think that is just where we are heading. England's respected Economist magazine, in a recent article entitled "The Approaching Depression," pilloried the world's rich nations for doing the very things sure to bring it on. If we have a depression, numerous bank failures would result as borrowers defaulted on loans--at a time when most banks cannot stand the collapse of even a few major borrowers. Most depositors assume that their deposits are safe; after all, they reason, the Federal Deposit Insurance Corporation insures every account up to $40,000. But the FDIC has only six billion dollars to cover 682 billion dollars in commercial bank deposits. As long as we have had only isolated and sporadic bank failures, this insurance program has worked perfectly.

This six billion dollars in reserves is the immediate source of protection for the nation's depositors. Although each account is now insured up to a maximum of $40,000, the FDIC always seeks to work out a plan that will protect all depositors, even those with larger balances than the insured limit. Nonetheless, it is only prudent for each individual to see that all his deposits are covered by FDIC insurance, especially today. This can easily be done by setting up multiple accounts, as the $40,000 limit applies to each account, not to each depositor. A married couple, for example, can maintain complete coverage on $120,000 per bank by setting up one account in the husband's name, one in the wife's and a joint account as well. For coverage beyond this amount, they could, of course, use more than one bank.

Over 99 percent of the banking system's total deposits of 682 billion dollars is in banks covered by FDIC insurance. If your deposits are in one of those very few banks not covered, you are taking a needless risk. Is the six billion dollars in reserves of the FDIC adequate to cover nearly 700 billion dollars in deposits? Frank Wille, the chairman of the FDIC, assured me that "We could easily handle several large bank failures, but not, of course, a general run on the banks." (The problem is that "several large bank failures" are exactly what might set off a "run on the banks.") Its reserves are currently growing at the rate of $400,000,000 a year, and the FDIC always has the option of going to Congress and asking for more money. So far, at least, either the Federal Reserve or the FDIC has been able to work out a merger for any large bank that has developed terminal trouble, without having to pay off depositors from the FDIC's reserves. But a rash of failures would make this kind of rescue operation nearly impossible and could throw the whole system into jeopardy.

In the past year and a half, the 100th largest bank in the country collapsed and the 23rd largest--the Franklin National of New York--also went under, despite a two-billion-dollar salvage effort by the Government. Recent articles in Business Week, Forbes, The Wall Street Journal and Fortune have begun to suggest the dimensions of the dilemma, but in a gingerly manner. They have all hastened to assure their readers that "it couldn't happen here," assurances that have had an increasingly hollow sound. Part of the reason for their delicacy may be their awareness that the very act of writing about the problems could bring on the disaster everyone hopes can be avoided. Thus, they have tended to place the blame on either the general world situation or the regulatory agencies and have avoided assigning any guilt where much of it belongs--with the managements of many of our largest banks.

For Americans, confidence in banks is almost second nature. This confidence, the base on which the entire system is built, has stemmed from more than just the existence of stern Government regulations and deposit insurance; it has come mainly from the until recently correct belief that banks were sound institutions run by prudent men, who believed that their primary responsibility was to their depositors. Now, however, many bankers are more concerned with pleasing their shareholders than with the ultimate safety of depositors' money.

Imagine that you have your money in a $10,000,000 bank--a small one as banks go. Its owners invested $1,000,000 of their own money to start the bank--that is the bank's capital. It takes in $9,000,000 in deposits--$6,000,000 in savings accounts, $3,000,000 in checking accounts. From this $10,000,000 available for investment, it makes $6,000,000 in loans, no one of which is likely to be bigger than $100,000. The bank buys a well-diversified high-quality portfolio of Government securities for $2,000,000. The remaining $2,000,000 is kept in cash. What's the risk? It would take an incredible combination of stupidity and bad luck for more than a few of the borrowers to default, assuming your bank held to the most basic standards of sound banking. It need just sit back, collect the interest on its loans and securities and pay you interest on your savings account. The bank need not worry if even its largest depositor decides to withdraw his money: It has that $2,000,000 in cash, ready for just such an eventuality. The bank makes a tidy profit, taking only the most minimal of risks.

Now, assume that this bank catches the eye of a much larger, expansion-minded institution, which buys it. This new bank--a devotee of "modern banking"--puts a bright young graduate of the Harvard Business School in charge. This "go-go" banker is not satisfied with that tidy profit, he wants to raise the rate of return, endear himself to the shareholders and get his picture on the cover of Business Week. First, he decides he wants to double deposits to get more money to swing with. He opens a few suburban branches, runs sprightly commercials on the local television station and offers checkbooks in eight decorator colors. The money rolls in and his deposits double. The TV commercials now proclaim his eagerness to lend you money ("We want to say yes!") and he has no trouble doubling his loans as well. But he sees that he is earning more money on his loans than on his Government securities or that idle cash he's been keeping on hand. So instead of lending out 60 percent of his total funds, as the conservative banker did, he lends out first 70 percent and then 80 percent. On his newly doubled base of deposits--$18,000,000--the 80 percent figure means loans of over $14,000,000, (continued on page 138) Banks on the Brink (continued from page 132) still backed by only $1,000,000 of capital. This is what the financial world calls leverage: It increases earnings, but it also introduces a major element of risk into the formerly riskless business of banking. The conservative banker would have had to see just under 17 percent of his loans default before his capital would be wiped out; the go-go banker's capital is gone if just over seven percent of his loans go bad.

At some point, our aggressive banker would find that he had reached the limit of how much he could expect to generate in the way of lendable funds. As soon as the demand for loans outstripped available bank deposits, he would turn to what is called "purchased money." This is money borrowed by one bank from another. But the "spread"--the differential between the interest rate at which the bank borrows and the rate at which it relends the money--is much narrower than when he used depositors' money as his source of funds. There is another disadvantage to these purchased funds: The bank from which they came can ask for them back at any time. If this happens, as it often does, the banker must scramble to find other money, perhaps at a still higher rate. A further element of instability--and therefore risk--has been added. But as long as the total of loans is going up, and there is still some spread, however narrow, earnings will grow.

Old-fashioned bankers took pride in the strength and solidity of their banks, as shown by their balance sheets. This is the document that sums up assets and liabilities, that indicates the ability of a given bank to meet its commitments. This is the statement that is of greatest concern to a depositor. Modern bankers, however, glory in their income statements, the totaling of their profits in a given year. They have discovered that this is what Wall Street cares about and that banks with steadily rising earnings appeal to buyers of stocks much more than banks still playing the game the old way. As the go-go bankers granted themselves huge stock options, rising stock prices helped them get rich.

When the leaders of any industry conclude that the old rules no longer apply, that they have discovered new ways to make money that escaped the notice of their less clever predecessors, one of two principles applies: Either it is not true at all or it may be true as long as the new system is practiced only by the brightest, strongest leaders, the true innovators. When everybody jumps on the band wagon, watch out. In the words of a leading Wall Street bank analyst, "All the followers are trying to play the leaders' game--and they just don't have the ability." A good analogy is the experience of the conglomerates. In the early Sixties, certain genuinely imaginative companies (Textron, Litton Industries) discovered the joys of combining unrelated businesses into an amalgam that would supposedly overcome the iron law of both physics and business: that nothing goes straight up forever. Vast numbers of imitators clambered aboard and, for a time, succeeded in convincing themselves, Wall Street and the world that two and two make five, or maybe even six. Along came the recession of 1970--1971, and most of the new converts to the conglomerate game found that two and two added up to three or to two or, in some spectacular cases, to zero. While the plummeting of conglomerate stock prices has few disastrous effects on the general economy, banks occupy a special position: Their problems are a source of worry not just for their shareholders but for everyone with a couple of hundred bucks in a special checking or savings account.

The Government enacted a series of laws, primarily in the Thirties, and a web of complex regulations to see to it that we are not dependent solely on the good will and innate conservatism of bankers for the safety of our money. One of the primary restrictions under which banks have operated in the past is a strict limitation on the kinds of businesses that they can operate. However, in 1963, the Comptroller of the Currency, who regulates all national banks, gave them the authority to form bank holding companies. This enabled them to acquire companies that were not bound by banking regulations. The new fields they entered were primarily consumer finance, commercial leasing and mortgage banking. While there is nothing sinister in the establishment of these vehicles, their use could jeopardize the depositors' money if the new ventures proved unsuccessful.

Today, just 12 years after these holding companies were authorized, all but a handful of the 50 largest banks in the U. S. are, in fact, the subsidiaries of such holding companies. A great attraction of these holding companies was that they permitted banks to diversify outside their normal territory. (Banks are normally forbidden to conduct a general banking business in more than one state, and in some states, such as Illinois and Missouri, they are not allowed to have any branches, even within that state.) The chance to diversify geographically proved very appealing, but one result was that banks sacrificed one of their greatest strengths: an intimate knowledge of their home territories.

As the permission of the Federal Reserve Board was required to make an acquisition, the authorities were not without some degree of control over the situation. At first this permission was routinely granted, but after a while, the Fed realized that banks were on an acquisition binge and that many of our largest banks were dangerously overextended. In the past year, the Fed has forbidden the ninth largest bank in the U. S. (First National of Chicago), the sixth largest (Bankers Trust of New York), the seventh largest (Chemical Bank of New York) and the biggest of all (Bank of America) to make acquisitions they were seeking. The denials included strongly worded statements on the "too-rapid expansion" by some of the banks. Just a few years ago, it would have been unthinkable for the Fed to cast official doubts on the management of such important banks.

The trouble with all this diversification is that, very simply, it has been a flop. The two most popular types of acquisition, mortgage banking and consumer lending, are businesses in which lending is done at a fixed rate for relatively long periods of time, placing a heavy drain on a bank's cash. These rates have long been higher than the interest a bank earns in its regular commercial lending operations--a fact that attracted the banks to these businesses in the first place. However, with the dramatic upsurge in interest rates during the past year, the banks are now locked into long-term loans at rates well below what they currently have to pay on the open market to attract funds. Many diversification-minded managements in search of higher profits are finding losses instead.

Another worrisome matter is "capital adequacy." A bank's capital is what would remain if it paid off all its outstanding liabilities--deposits held by individuals and corporations, money it has borrowed from other banks and money it has borrowed from agencies of the Federal Government. This remainder--capital--is what the bank's shareholders actually own, but it is of interest to more than just the shareholders. Capital provides the margin of safety that ensures the ability of a bank to survive, even in a depression.

Back in 1960, the average U. S. commercial bank had liabilities that were only 11.3 times its capital. By 1970, this ratio had grown to 13 and by the end of 1973, to 14.5 times total capital. However, when we look only at the 30 largest banks, we find a still greater jump. At the end of 1973, their liabilities were 16.7 times their capital. For some of the very largest banks, the figures are still more lopsided: Bank of America, Bankers Trust of New York and Crocker National of San Francisco all had liabilities more than 30 times their capital, and the Union Bank of California and the Republic National of Dallas were very close to that level. This can have dangerous implications. Just before its serious troubles began, the now-defunct Franklin National also had liabilities almost 30 times its capital. Even if it had had more capital, it would still have suffered the massive losses it did, but it might have been able to survive them.

The problems we've seen so far--(continued on page 199) Banks on the Brink (continued from page 138) excessive concern with earnings, unwise diversification, insufficient capital--are not in themselves enough to cause a wave of bank failures. But here are other difficulties further clouding the picture. Corporate treasurers, who used to be content to let a few million dollars lie around in non-interest-paying checking accounts, now realize that every dollar possible should be at work earning the extremely high interest rates available today. Thus, money has been moved from checking accounts into a relatively new instrument, the certificate of deposit. These are sold only in multiples of $100,000, currently pay in excess of 11 percent and are issued for short periods--commonly 30, 60 or 90 days. In the past two years, the total of these C.D.s purchased by customers of the 30 largest U. S. banks has risen 135 percent, or 46 billion dollars. During the same period, interest-free demand deposits--checking accounts--rose only 13 percent. Bankers would obviously rather pay nothing than pay 11 percent. Not only are C.D.s a more expensive way for a bank to raise funds but they are also an inherently less stable source of money. Sudden shifts in affection by the buyers of C.D.s can occur, leaving the out-of-favor bank dangerously short of funds.

The increasing use of C.D.s by banks to raise money is the direct product of the mania for growth of our new-style bankers. When a bank was content to operate within a defined community, it usually had an equally defined, loyal group of customers. Their deposits were a stable base on which a bank carried out its lending activities. Today, the large banks are all engaged in a fierce nationwide competition for money, bidding against one another for the excess funds of large corporations and investors whose only loyalty is to the highest possible return on their money. If we enter a period of severe world-wide recession, banks could find many of their borrowers going broke. These narrow spreads created by the C.D. war give less breathing space before any defaulted loans wipe out a bank's profits, or even create losses--losses that reduce the dangerously low levels of capital still further.

Such defaults by borrowers are the most obvious way a bank can lose money. In the past few years, there has been an ominous rise in the number of bad loans, despite general prosperity. In 1973, many of the largest banks were hit by a rising tide of uncollectible loans: Bank of America, Chase Manhattan and Bankers Trust all showed more than a 50 percent jump in bad loans from the prior year; at First National City Bank, loan losses doubled those of the previous year; and for the First National Bank of Boston and the Irving Trust of New York, both among the 20 largest banks in the country, the comparable figures were triple those of the prior year. Part of the reason for this is that banks, in search of higher returns, have increased their lending in such areas as real estate, where the rates are higher because, simply, the risks are greater.

The current upward spiral of interest rates introduces yet another element of added risk: Most loans to large borrowers--unlike consumer loans--are made at a rate that rises or falls with the prime rate, the amount banks charge their best customers. Two years ago, when the prime rate was six percent, a borrower may have taken out a five-year loan at two percent over prime, or eight percent. Today, he is paying 14 percent for that same loan, and the added interest burden may be just enough to tip the scales: A builder who had no trouble making payments at eight percent may be forced into bankruptcy when the rate reaches 14; thus the entire loan is defaulted. Speaking of the increasing number of defaults by borrowers, one banker suggested that the problem is likely to get worse. He pointed out, "In the banking business, we use the old exterminator's rule: If you've got one rat, you've got 50." All of this adds up to one thing: Banks have never been less able to withstand a serious economic shock wave. When and if that small shock wave comes, it will most likely come from overseas.

At the end of 1964, just ten U. S. banks operated abroad. Together, they had a modest total of 5.8 billion dollars in overseas assets. By the middle of 1974, 125 American banks had branches abroad, with 147 billion dollars in assets outside the U. S., a staggering 2500 percent increase. There are simply not 125 American banks, possibly not even 25, with enough experience and skill to operate successfully in the complicated and clubby world of international finance. Eliot Janeway, a maverick but respected economist, described the bankers' rush overseas, particularly to Europe, this way: "They were like a high school kid who'd just had his first piece of tail--they wanted to know why someone hadn't clued them in earlier on how great it was." What made overseas banking seem so appealing to the new participants was very simple: its profitability. According to one international banker, the spread overseas was double what the bank was earning domestically.

When novice bankers got to London, capital of international finance, they found a complex and different way of doing business, far higher costs of operation than those in the States, the intricacies of currency fluctuations and much lower spreads than those that had beckoned them there in the first place. For the Americans were not the only new entrants in the game; the Japanese also saw in Europe a place to flex their financial muscle.

The newcomers to the international scene lacked a base of clients with a long-established loyalty to them--as they were used to at home. So they had to scramble to establish new relationships, get deposits, compete for borrowers. This proved very difficult. If you were a large European corporation, would you give your money to the Morgan Guaranty, the titan of international banking, or to the fifth largest bank in Detroit, which had just opened its London office? Would you choose Barclays--Britain's biggest--or the London branch of the First Wisconsin National Bank of Milwaukee?

Most European countries have only five or six major banks, many of them partly owned by the government. A few well-established American banks had been given club membership years ago, and they were none too happy to see their fresh-faced junior brethren from the States arrive. These newcomers ended up doing what newcomers usually have to do: They took what they could get. In some instances, the big banks would take them in as junior partners on loans that were bigger than they could handle by themselves. But loans were not as big a problem as deposits, for it's generally true that giving someone money is a little easier than getting it from him. The arrivistes solved this in the classical manner of someone trying to break into a new market: They paid more. Although maybe it was only one eighth or one quarter percent more, it served to narrow the already slim margins that the wave of new competition had produced.

By bidding higher, the recent arrivals did manage to raise large amounts on the European money markets. The four largest banks in Texas, for instance, joined the European bonanza in the late Sixties. In 1969, they had among them only $39,000,000 in foreign deposits; by June 1974, this figure was 3.2 billion dollars, an 82-fold increase.

Having obtained these deposits abroad (U. S. Government regulations at the time prevented them from simply shipping money over from the home office), they then had to put these funds to work at a high enough rate to cover their costs. Although European practice dictated extremely short maturities for deposits--30 days to six months at most--the loan demand was for much longer periods, five to eight years being standard and 15 years not being unusual. This was particularly true for the new banks, which didn't have their pick of the best loans. Also, it is a general rule of banking that the longer the term of the loan, the higher the interest rate. Tied as they were to high-cost deposits and eager to show immediate profits, these banks had little choice but to make these loans. This left them "borrowed short and lent long"--a financial-world phrase that spells potential trouble. Although it is customary in banking to have a loan portfolio with longer maturities than those of your deposits, this is only a problem for banks without a stable base of deposits, the very thing these new foreign branches of U. S. banks lacked.

Much of this money, borrowed at very high rates, was simply redeposited with other banks, usually at a very narrow interest spread. Why were other banks in Europe willing to pay still more for money than these banks had paid to get their deposits? The answer is that outside the U. S., where regulations are much less strict, not all banks have equally good credit ratings. The lower a bank's standing, the more it has to pay for its money. Thus, much of this massive flow of funds the new U. S. banks garnered was redeposited with banks of secondary quality, because only they would pay enough for funds to make this money-trading operation profitable for the players. Can some of these banks into which the American banks have put their money go under? Not only can they but some already have, with large losses to certain U. S. banks. More collapses are expected, as rumors swirl daily about this British bank or that French bank that is said to be in trouble. The possibility of a series of bank failures has created the European financial version of the domino theory.

When knowledgeable observers look at the lending practices of many of the recent arrivals on the international scene, they shudder. Back in the States, these banks became successful because they had an intimate knowledge of their territory and its economic conditions. They could properly assess the ability of a borrower to repay his loan, based both on their long experience and on the greater availability of detailed financial data in the U. S. When they went to Europe--or Asia or Latin America--these advantages evaporated. One Dallas banker, whose institution had gone from zero activity abroad to 1.2 billion dollars in foreign assets in just a few years, confessed to me: "Five years ago, if someone walked into our bank with a traveler's check, we didn't know what to do with it. Today, we're making loans in Ruanda."

One substitute for normal credit analysis was a simple reliance on the good name of a borrower. In the United States, there is no better credit than that of the Federal Government. Transferring this attitude to international lending has so far proved dangerous and could soon prove disastrous. The Italian government, everybody's current favorite nominee as the borrower whose default could touch off a collapse of the entire international financial structure, has a total of over eight billion dollars--more than its total reserves--of relatively short-term debt to the private banking system. The banks allowed Italy to get overextended because they felt its status as a leading Western government automatically made it a good credit. Now they are belatedly seeing that governments can become technically, or even actually, insolvent, just as the Penn Central did. The tripling of the price Italy had to pay for oil took it off the marginal list and put it on the critical list. But it is not the only financial basket case among the nations of the world; Greece, Mexico and Peru together have a total debt to the banking system that exceeds their reserves.

If the U. S. banks that sought to expand overseas were handicapped by their lack of experience in foreign lending, they were positively crippled in the area of currency trading. In the U. S., a dollar was a dollar. Maybe it declined in purchasing power, but then, so did everybody's dollars. Suddenly the banks were plunged into a world where a dollar was a constantly and violently fluctuating number of francs or marks or pounds or yen. Here banks again fell into a trap because of their zeal to show higher earnings. Instead of contenting themselves with those currency trading operations necessary to the normal banking function, many banks decided to become speculators, to pit their meager and newly acquired skills against those of the Swiss bankers and other Continental experts with decades of expensively acquired knowledge.

The dangers of this became apparent just recently, when the Bankhaus Herstatt collapsed under the weight of losses from its freewheeling currency speculation. Hours before its collapse, it entered into numerous transactions with large American banks that were then left holding the bag. Not even the mighty were immune: Morgan Guaranty lost $13,000,000 in one of these transactions, not a small sum even for it. Other American banks that suffered large losses when the Herstatt folded included Chase Manhattan First National City, Girard Bank of Philadelphia, Wells Fargo, First National of Chicago and Manufacturers Hanover--as blue-ribbon a list as you can ask for. But most devastating--and most revealing--was the loss of $22,500,000 by the Zurich subsidiary of the Seattle First National Bank. This bank had proudly mentioned in its 1973 annual report that its Zurich subsidiary had earned $536,000 that year. At that rate, it would take it 42 years to make up what it lost in one day. An extremely knowledgeable international investment banker posed this not-so-rhetorical question to me: "What the hell were they doing with a Zurich subsidiary in the first place?" It made about as much sense as if you were to enter the family sedan in the Indianapolis 500.

• • •

Federal regulation of the banking industry is aimed at the prevention of crises. But it is only when the situation becomes critical that the regulators take charge. The Federal Reserve Bank is the primary regulatory agency. It has essentially two separate functions: It controls the money supply of the country and, in doing so, plays a central role in managing the nation's economy; it also sets the rules under which those banks that are Federal Reserve members operate. Fed members control nearly 80 percent of the banking system's total assets and include all but a handful of large banks. When the Fed tried to rescue the Franklin, it was acting in the role of "lender of last resort," as it is ominously described in banking circles. Simply put, when a bank is in trouble and no one else will lend it money, the Fed has the option of bailing it out by advancing it sufficient money to keep it afloat. This is what it did, unsuccessfully, for the Franklin, to the tune of 1.77 billion dollars.

What has scared many bank analysts is the possibility that not one but two or three major banks will need similar help at the same time. As the Fed is presently (concluded on page 204) committed to a "tight money" policy, pumping billions of dollars into a number of tottering banks could wreck that policy and set off still greater inflationary pressures. Would the Fed sacrifice its over-all monetary policy to prevent multiple bank disasters? The answer definitely is yes--as signaled by its attempted rescue of the Franklin. This was not done out of concern for the Franklin's shareholders--whose shares are probably now worthless--but out of fear of the blow to depositor confidence that would result from such a large bank's going under. A similar signal was given in 1970, when the Penn Central's demise also caused the Fed to inject billions of dollars into the banking system, rather than attempt to protect the tight-money policy.

Could the Federal Reserve, by more closely policing the actions of its member banks, have kept a bank like the Franklin from reaching the crisis stage, at which point the Fed had little choice but to come to its aid? The answer lies with the members of the Fed's seven-man ruling Board of Governors and the way it sees its role. Five of these seven men are Nixon appointees, and one was recently appointed by President Ford. Nixon tried, as with his Supreme Court nominees, to pack the Federal Reserve Board with extreme conservatives who would allow business to operate as free of Government interference as possible. Unlike his Supreme Court choices, Nixon's Federal Reserve Board appointees have not disappointed him. John Bunting, the articulate head of the First Pennsylvania Bank, the largest in Philadelphia, characterized all of these men as "classical laissez-faire economists and businessmen who oppose an active, interventionist role for the Fed." Its chairman, Arthur Burns, a Nixon appointee, is greatly respected, but he, too, has clearly indicated his preference for letting the market place determine such crucial matters as interest rates and the availability of bank credit.

The one strong voice for an activist Fed policy was that of Andrew Brimmer, a Johnson appointee, who resigned from the Board of Governors this past August. Shortly before his resignation, we met in his office in the imposing headquarters of the Federal Reserve. Brimmer (incidentally, the first black to serve on the board) has consistently fought a losing battle for stricter regulation of the banks. He has been persistent in his warnings about the dangers of excessive expansion, especially abroad. He has opposed the board's near-total reliance on "voluntarism" and has called on Congress to put more teeth in the banking laws. He agreed, though, that the Fed already has powers it isn't using and that new legislation alone wouldn't solve the problems.

What if the Fed had not kept the Franklin afloat until a buyer could be found? Without help, it would never have been able to withstand the loss of 1.7 billion dollars in deposits and would have been forced to close its doors. In such cases, the FDIC exists as the last line of defense. At the time the U. S. National Bank of San Diego went under, the situation was clearly beyond shoring up by the Fed in the manner it chose with the Franklin. There the FDIC acted to arrange a sort of shotgun marriage with the Crocker National of San Francisco, the 15th largest bank in the country. Under the plan that evolved, Crocker assumed all the deposit liabilities of the U. S. National. The FDIC had to lay out $500,000,000 from its reserves to effect the merger; it hopes to recover a good portion of this sum, but it will doubtless suffer some loss.

Although there are no simple steps that the Government could take to guarantee we'll avoid a panic situation, some measures would go a long way toward raising public confidence, alleviating the present problems and preventing banks from getting overextended again. One very important and much-needed change was recently made, when, on November 27, 1974, the insurance limit was raised from $20,000 to $40,000 per account. The regulators should urgently consider the following recommendations:

1. The cost to banks of FDIC coverage on their deposits currently is only about 1/23 of one percent of all deposits. This is far too little for insurance that no bank would dare do without and at a time when there is legitimate worry about the soundness of many institutions. The cost should be raised for all banks, and this cost should be related to the bank's capital ratio. The higher the ratio, the greater the risk of failure, making it only fair that such a bank pay more for Government insurance. This provision would offer the banks further incentive to reduce their excessive capital leverage.

2. The Federal Reserve should be much stricter in limiting the deposit and loan growth of banks it considers undercapitalized. The careful winding down of this situation will take time, but it should start as soon as possible.

3. The Fed should implement a still tougher standard on all acquisitions; only if the bank operation is completely sound should it be allowed to increase its involvement outside banking.

4. Banks should be required to disclose to the public detailed information about their lending activities; of prime importance are a breakdown of the kinds of outstanding loans, their average maturities, the number of delinquent loans and the amount in loan losses the bank has suffered during each of the past five years. This should be required information in their annual reports, which should be available at all branches of each bank.

5. Foreign lending activity should be much more strictly supervised, with an immediate halt to any increase in loans ordered if a bank fails to meet certain set standards of safety.

6. Banks are required to maintain special funds to cover potential losses from defaulted loans. These are called loan-loss reserves. These reserves are computed by a method that does not accurately reflect what may be the true condition of a bank's loan portfolio. As an example, last year the First National City Bank had a 32 percent increase in loans outstanding but only a .25 percent increase in its provision for future loan losses. The Chase Manhattan from the beginning of 1972 to the middle of 1974 increased its loans outstanding 79 percent but its loan-loss reserves only ten percent. These banks, and all others, are following the letter of the law on this matter, but the law should be changed to require that any increases in exposure to loan losses be matched by equal increases in reserves. Otherwise, banks are misleading the public about their profitability and possibly even their soundness.

These steps would represent no cure-all but only a modest attempt to ease the current situation. They do have the virtue of not exerting any negative effect on the banks' ability to finance legitimate business-loan demand.

As we have seen, the banks' own internal position leaves them with little ability to withstand any of a number of possible external problems. Should trouble come, the banks have left themselves little room to maneuver. Thinly stretched bank capital. Unwise loan policies, especially in the real-estate area. And worst of all is the ill-planned and excessive growth of liabilities, particularly abroad, where the general situation is far worse than here, and many of our regulatory safeguards do not exist. If the present inflation continues, with interest rates going still higher than today's unprecedented levels, numerous corporate bankruptcies will prove unavoidable.

On the other hand, if the Federal Reserve really is resolved to "break the back" of inflation, then that, too, could easily cause a depression and bring on a round of bankruptcies that would place almost unbearable burdens on the banking system. This possibility is what worries Bunting of First Pennsylvania the most: "Businessmen have been assuming that major depressions were a thing of the past, and they are unless the Government is serious about ending inflation over the near term; if what they're saying is more than just rhetoric, I shudder to imagine the results." The dilemma could not be more acute: Too much inflation, and we're bound to see a number of banks fail; too heavy-handed an attempt to slow down inflation, and the results are equally scary. These problems won't vanish overnight; even if we avoid calamity, the system is badly strained and the repairs will take years. As one banker put it: "It's a game of musical chairs. There are more asses than chairs, and everyone wants to be sure he's seated when the music stops."

The Fall of the Franklin

When we look at most large banks today, we see a variety of difficulties caused by lack of foresight and the too-aggressive pursuit of growth. When we turn to the Franklin National, we can add monumental greed, overweening arrogance and possible fraud to the picture. The transformation of the Franklin from one of the most successful suburban banks in America into a tottering wreck that almost set off a full-fledged panic encapsulates all of the ills described so far. In the mid-Sixties, before the Franklin joined the trek overseas in search of expanded profits, it enjoyed all the benefits of being the dominant bank in the Long Island suburbs of New York City, one of the richest and fastest-growing areas in the country. But it smarted under the description "country bank.' " a term applied equally to all banks, whatever their size, outside major cities. In 1969, it opened its first overseas branch, in London. Assets abroad grew rapidly, reaching 1.1 billion dollars by the end of 1973; but the hoped-for profits never materialized. Despite a growth in total assets of three billion dollars since 1966, its profits did not grow at all. This increased volume may have made the officers feel part of the big time, but it didn't do anything for the shareholders or the depositors.

The 1973 annual report, which flagrantly masked a rapidly deteriorating situation, sonorously intoned, "As Tolstoy pointed out, man becomes aware of change not while it is going on, only when it has taken place." This was certainly true for those customers of the bank who assumed it was a sound institution. The annual report went on: "Franklin is ideally suited by corporate temperament and tradition to adapt quickly to the vast revolutionary changes anticipated in the new local, national and world order." Subsequent events made this a bitter joke.

Enter now Michele Sindona. This shadowy Italian financier, with admitted connections to the Vatican and rumored connections to the Mafia, had built a huge fortune in postwar Italy through complicated and secretive wheeling and dealing. In 1972, he bought a controlling interest in the Franklin. Immediately following this, the Franklin plunged into foreign-currency trading--that is, speculation. In 1973, this activity became an important source of profits, more than 50 percent of the $13,000,000 net income reported by the bank. However, by the first half of 1974, these profits had turned into massive losses, about $83,000,000. How had this happened? No one knows for certain yet, but simple incompetence cannot be the whole story. A respected foreign banker pointed out to me that in foreign-exchange dealing, if someone takes a loss, someone else must make a profit. After a promise of anonymity, he strongly hinted that the answer could be found in Sindona's Sicilian origins. Eliot Jane way, as usual, was more direct: "Sindona was trying to use the assets of the Franklin to bail out the Italian government, which is like trying to use a teacup to bail out the Atlantic Ocean."

As soon as the announcement of the losses was made, an orderly but rapid run on the bank began. Depositors withdrew 1.7 billion dollars in a short time, causing the Federal Reserve to try to shore up the breach with loans of over 1.2 billion dollars. (The six largest New York banks also--after a little arm twisting by the Fed--lent the Franklin an additional $225,000,000.)

Then, the FDIC undertook to auction off the Franklin, with three large New York City banks--Chemical, Manufacturers Hanover and First National City--all entering the bidding. In October, the FDIC announced that the winning bank--if acquiring the Franklin can be considered winning--was a fourth entrant, the European-American Bank and Trust. European-American is a U. S. bank owned by a consortium of six of the leading European banks--the Deutsche Bank, the Amsterdam/Rotterdam Bank, the English Midland Bank Group, the Creditanstalt-Bank verein of Austria, the Société Générale of France and the Société Générale de Banque of Belgium--representing a total of over 96 billion dollars of banking assets.

European-American under the terms of the agreement was allowed to pick and choose among those assets, primarily loans and securities, of the Franklin that it wished to acquire; these totaled 1.7 billion dollars, sufficient to offset the 1.4 billion dollars in deposits that remained in the Franklin, plus an additional $300,000,000 of other liabilities. For this, European-American paid $125,000,000, acquiring in the process the entire domestic branch system of the Franklin. Thus, not one depositor in the Franklin lost any money.

As the Franklin had, subsequent to its series of troubles, 3.7 billion dollars in total assets, this left two billion dollars of remaining assets, which the FDIC hopes will be sufficient to repay the final total of 1.77 billion dollars that the Federal Reserve lent the Franklin when it was trying to keep it from going under. (The New York City banks that had lent the Franklin an additional $225,000,000 were repaid by the Fed just prior to the purchase by European-American.)

There was some consternation among Government officials and the banking industry that this major U. S. bank was being acquired by foreign interests, and some suggested that the bid of Manufacturers Hanover, which was only slightly lower than the $125,000,000 paid by European-American, be accepted in preference to control of the bank's passing into foreign hands.

The FDIC, under its chairman, Frank Wille, to its credit rejected such reasoning and said that its primary responsibility was to get the highest price so as to reduce to the absolute minimum the loss the FDIC and, by extension, all depositors in U. S. banks might have to suffer. It will take three years to unwind the situation, but it is quite possible that the current plan will allow the Federal Reserve to be repaid fully with interest, and it is possible the remaining assets of the Franklin will prove sufficient to repay this indebtedness without dipping into the FDIC's reserves. If this occurs or even if the loss is held to a relatively modest sum, the Government regulators deserve high marks for skillfully managing a potentially disastrous situation without jeopardizing other banks and without serious loss to the Government and without significant negative impact on Americans' trust in the soundness of their banking system.

It is ironic to note that the Franklin got into trouble because it ventured way beyond its depth in overseas banking and that, as a result, control of one of the largest U. S. banks passed into the hands of European bankers. Although the Franklin story involves some special elements all its own, it nonetheless reflects most of the ills described in the accompanying article, which are the outgrowths of many bank managements' zeal for growth with insufficient concern for classical sound banking practice. If the Franklin debacle produces a much-needed rethinking of their attitudes by bankers, then it will have served a salutary purpose.