The State of the Banks

The vitality of Western economies is based, in important ways, on the health of our credit system. This system depends on the actual financial strength of large Western banks, on the financial and fiscal policies of Western governments, as well as on public psychology. Today, for a variety of reasons, we are witnessing a loss of confidence in our banking system which, if allowed to continue, could have serious repercussions.

The word “credit” derives from the Latin credere: to believe. Prudence on the part of lenders and borrowers has to be supported by the general belief on the part of consumers and depositors that the system will work. Today, this belief has become perilously fragile. It is not fragile, as some bankers may believe, because “there is too much loose talk about the problem.” By now, every responsible businessman should know that the word “crisis” is newsworthy and that press and TV reporting make it utterly impossible to avoid serious questions about the banking system, even if it were desirable to do so. Furthermore, it is undeniable that both the known facts and the potential problems argue against a policy of hoping to muddle through with a little bit of luck. The risk of inaction is simply too great.

During the last decade, major changes have occurred in the organization and functioning of Western economies, world trade, and the distribution of wealth among nations. All of these changes, in one form or another, are causes for the enormous pressures that weigh on our banking system.

The first of these causes lies in the international economy. The world today appears to have entered a deflationary cycle. For the first time since World War II every industrially developed country is in various stages of recession. Unemployment levels are rising and inflation rates are coming down. Real interest rates are still prohibitively high and financial pressures are causing cutbacks in industry and government. In the US, the fight against inflation appears to be successful; we may, however, find that success carries a heavy price. The impact of US deflation on the rest of the world is staggering: recession, unemployment, and collapsing raw material prices are a worldwide phenomenon. There can be no worldwide recovery without a US recovery; the US has to be the locomotive.

Second, the demise, in 1971, of the arrangements made at Bretton Woods in 1945 caused the breakdown of an international monetary system which made the years between 1945 and 1971 among the most successful in the history of monetary management. Indeed for all countries, rich and poor, this was the most fruitful period in the history of the world. Harold Lever, who has one of the most brilliant financial minds in England, said in December 1981: “Bretton Woods was itself the greatest single achievement in terms of creating an institution which would bridge the growing interdependence of the world and national decisions.” The effect of the Bretton Woods agreements was to make the dollar the world’s reserve currency, against which every other major currency was pegged. When the Bretton Woods system broke down with the floating of the dollar in 1971, no country or group of countries was able to assume the responsibilities that had been carried by the United States; no international currency was substituted for the dollar. Bretton Woods was replaced by nothing, and the OPEC oil shock of 1973 was superimposed on a world monetary system that had been completely disrupted.

Third was the distress caused by the rise of oil prices after 1973. OPEC created huge, long-term balance-of-payments deficits in many countries of the world whose economies were shaken by high energy costs they could not pay for. Lacking an adequate monetary system, the rich and poor nations had to resort to the policy of “bank recycling.” This was a process whereby OPEC oil producers deposited their surplus cash with Western banks, which then lent the money partly to poorer non-oil-producing countries in need of credit. There was, at the time, no alternative to bank recycling other than direct OPEC lending to third-world countries, and OPEC loans to such countries remained relatively small.

However, the effect of bank recycling was to lend more and more to less-and-less-credit-worthy borrowers; it meant ever greater burdens on weak borrowers. Running as high as $100 billion per year, OPEC surpluses were deposited with Western banks which lent part of them throughout the world. No doubt both some of the banks and some of the borrowing countries were incautious and overeager in arranging these loans. By 1982 the third world’s debt reached $500 billion, most of it in the form of shortterm debt.

Fourth, during the Seventies, “détente” governed our relations with the Soviet Union and Eastern Europe. Mutual economic interests would, it was thought, help create an atmosphere in the Soviet Union which would restrain its geopolitical behavior while a step-by-step process of limiting and reducing arms could take place. Encouraged by their governments, Western banks lent Eastern Europe over $50 billion between 1972 and 1982. The collapse of both détente and the Eastern European economies abruptly halted this process.

Last but not the least important was our appetite for credit in the US itself. Growth and inflation were the dominant economic trends of the 1970s, interrupted here and there by recession in one Western country or another, but never at precisely the same time among all Western countries. The high rates of inflation sharply lowered real interest rates and permitted heavy borrowers to “service” their debts—i.e., pay both interest and installments of the principal—with cheaper currency. The conviction grew among many business leaders, especially in the US, that inflation was here to stay. As a result, the use of credit soared. In 1950, the average US corporation had $43 of operating income to meet each dollar of interest payments; today, the average corporation has less than $4 to meet each dollar of such payments. Liquid assets are down to 24 percent of short-term liabilities, half of what they were during the 1950s. The ratios of short-term debt to long-term debt on corporate balance sheets have climbed from 40 percent in the 1950s to 70 percent today.

Short-term debt has been used not only to provide long-term capital assets such as new plants but much else besides, including real estate and other speculations, and larger and larger corporate takeovers. Normal prudence would have required much greater use of long-term credits, but their high interest cost was often deemed prohibitive. As a result, many American corporations under heavy obligation to repay short-term loans now find themselves short of “liquidity”—cash or assets convertible into cash; and the banks, the providers of short-term credit, have become more and more “exposed”—i.e., are owed increasingly large sums in relation to their own assets.

It is dangerous to generalize. Not all banks are in trouble; not all countries pose similar credit risks. However, the interdependence of the international monetary system is such that, in some respects, the system is only as strong as its weakest links. We cannot, for instance, ignore the situation of Canadian banks. The absence of any legal lending limits, a government policy of financing Canadian repurchase of energy assets, and the collapse of the local economy—all have contributed to the dangerously overextended condition of the Canadian banking system. German banks have made large and often risky loans in Eastern Europe; Belgium’s second largest bank faces a $200 million loss with an obscure Saudi foreign-exchange trading firm. These are matters of concern to all of us even though the respective central banks have the direct responsibility as ultimate lenders.

Completely outside the system is a network of banks for which no central bank is directly responsible. The best current example of such “rogue” banks is the Italian Banco Ambrosiano in which the Vatican is reported to have lost over $1 billion and whose Luxemburg subsidiary owes Western banks over $400 million. Nobody really knows the size of the outstanding loans of banks in such tax-shelter havens as the Cayman Islands. It could be significant.

When New York City faced its crisis, some argued against full disclosure of the magnitude of the city’s problems, above all its inability to borrow more money in view of widespread skepticism about its ability to pay. It was argued, not without some justification, that disclosure would bring on the very crisis the city was trying to prevent. Those of us who were asked to help the city chose to disclose the facts while at the same time coming forth with a plan to resolve the crisis. It was a correct, if probably inevitable, decision. The same must now be done on a much vaster, more complicated scale.

The unknown in many ways is scarier than the known. Rumors about the shaky condition of this or that bank are creating financing difficulties for some American banks, notwithstanding the widely shared judgment that the Federal Reserve would never permit a major American bank to default on its obligation to depositors. It is imperative that steps be taken, rapidly, to restore confidence in the banking system, both domestically and internationally.

The steps outlined here are not necessarily a “solution” to the problem: there may be no solution short of a decade of strong, worldwide economic growth. They are, rather, intended to suggest a coordinated process that would shore up the system and avoid a crisis. Several discrete issues will have to be faced very soon if, during the next three to five years, we are to avoid a financial breakdown.

1) The US banking system must be strengthened. According to the Federal Reserve, as of May 1982 US banks have lent over $300 billion abroad. This includes $200 billion in Latin America, the third world, and Eastern Europe. To put these numbers in perspective, it is worth noting that the total equity of the thirty largest US bank holding companies as of mid-1982—i.e., the value of their assets above their total liabilites—was about $40 billion. American banks are major participants in Mexico’s $80 billion of external debt, as well as Brazil’s $60 billion and Argentina’s $40 billion. The risks to American banks of an unexpected default by these and other countries would therefore be grave ones.

Complicating the situation are certain illusions and accounting practices that shape many banking decisions. It is, in my judgment, an illusion to think that no sovereign country will default on its external debt because it would become a pariah in the international financial community. Default or a repudiation of debt could occur as a result of radical political changes (as is possible in literally any Latin American country) or geopolitical decisions (as might be the case in Eastern Europe).

At the same time, the prevailing accounting practices show more than a few banks making higher operating profits by “rolling over,” or extending, highly questionable debts from borrowers like Poland, thereby avoiding writing them off as a loss. This practice creates a dangerous illusion. A bank’s operating results appear to be improved as it takes on greater and greater debts from risky countries, and the bank becomes more and more the prisoner of the borrower.

For loans within the US the risks, although significant, are usually more manageable. First of all, the legal lending limit allows an American bank to lend no more than 10 percent of its capital to any one borrower. This restriction, however, does not apply to “country risk,” namely the aggregate of loans to any one country. By lending to several differant government entities, as well as to private businesses, in a foreign country. a bank may put at risk a much greater proportion of its capital. It is no secret that several major American banks have an important share of their capital on loan in Mexico, Brazil, and Argentina, Furthermore, because the risks in the less developed countries and Eastern Europe are more subject to foreign politicial decisions, they are also less predictable and more sudden than the domestic equivalent.

The fact that International Harvester may go bankrupt has been known for some time. The same is true of Dome Petroleum in Canada or AEG in Germany. In one way or another such companies can usually be reorganized. Certain of their assets can be sold off; the shrunken remainder of the company can be merged with another company, or run independently; and so a rescue plan can come about. The potential bank losses, although severe, do not pose a danger to the system. There have been surprises of course: the failure of Penn-Square Bank in Oklahoma and of Drysdale Securities and Lombard Wall in New York; not to mention the Hunt silver caper. These were sizable cases of acquisition of very risky short-term debt; but they could be contained. Excessive international debt requires additional safety precautions.

We now have only one half of a safety net for our American banks: the Federal Reserve system, which can supply liquidity to a bank, as a lender of last resort. We need, in addition, an organization that can supply capital as an investor of last resort. I have, for some time, argued for the creation of a modern version of the federal Reconstruction Finance Corporation of the 1930s. An RFC could be such an investor, as it was originally to thousands of banks and other financial institutions.

The possible need for capital, as opposed to liquidity, could arise out of a major default that required, for legal and accounting reasons, a write-off of such magnitude as to impair a major bank’s capital, and therefore its ability to lend and function. The RFC, or a similar institution, would have the authority to acquire preferred stock of banks with capital problems. The RFC would thus both supply capital and relieve the danger to a bank caused by a sudden, major default. It would permit an orderly settlement of the bank’s obligations. It would give our banks protection against a sudden political decision in foreign countries to renege on payments or even to practice financial blackmail in the form of a threat to bring down American banks unless more credit were extended. The mere existence of such an arrangement under the RFC would help remove the present widespread concern about the soundness of our banks, which is clearly detrimental to an economic recovery. Any investment by the RFC would have to be part of an overall plan, under the control of the Federal Reserve, whereby standby loans would be provided by the Fed and more permanent capital by the RFC.

This is a limited, but direct, form of federal intervention in the banking system. An alternative would be less visible but more open-ended. If a major foreign loan were suddenly in default, it could be assumed by the Federal Reserve at its “discount window,” that is, the channel through which the Federal Reserve regularly lends money to US banks, Like the RFC, this approach would seem to require legislation since the Fed can now only make loans to member banks against full collateral. It is, however, a workable approach to the problem and could be part of a program to give the banks time to recognize the impact on their capital.

I recently advocated a plan that would acknowledge the bankruptcy of Poland and provide that Polish loans held by the private banks be taken over by their respective national banks. I proposed that the central banks pay the private banks fifty cents on the dollar in assuming a debt that the Polish government has no realistic prospect of paying. This would be essential to the safety of some German banks. The principle of both the interventions I have mentioned is the same, whatever the numbers. And the principle underlines the political question which must be faced, sooner or later, of who will pay the ultimate costs if a bank faces failure. Both the taxpayers and the bank’s stockholders will have to assume a part of such costs if the banking system is to be protected; what must be worked out will be the proportion of costs each will share.

These are steps that would shore up the domestic banking system insofar as the past is concerned. As to the future, clearly some changes in regulation are required. The most obvious would be to extend the principle of the legal limit now applicable to one borrower to “foreign country risk” as well. An American bank may lend an amount equivalent to no more than 10 percent of its capital to IBM; but it can lend an aggregate 100 percent of its capital or more to various Mexican entities. Clearly this makes no sense. Whether the limit to a foreign country should be 10 percent, or perhaps 20 percent as is the case with Japanese banks, is arguable. The principle seems to me unquestionable, and should be implemented as soon as possible.

2) The international institutions must be strengthened. Clearly, the US must support the IMF, the World Bank, and the Bank for International Settlements. Each of these institutions draws on funds provided by the richer nations to supply credit to countries in economic difficulty. Doubling the IMF’s capacity to lend money from its present $60 billion or so does not seem excessive; whether it is done directly or partly by a special emergency fund, as the Reagan administration suggests, is a matter of choice. The real question concerns the role of the IMF in the present world economy.

When New York City faced bankruptcy, we were able to re-establish its credit by imposing austerity measures and refinancing its short-term debt through state institutions such as the Muncipal Assistance Corporation and the Emergency Financial Control Board. A buoyant economy, coupled with these austerity measures, allowed us to succeed without unacceptable social trauma.

The IMF can be seen as a worldwide version of MAC. But it will try to impose the same sort of austerity program in a worldwide economic environment not of growth but of contraction and deflation. In many countries seeking IMF loans, the gulf between social classes is enormous and the prevailing political realities may deny the possibility of the austerity measures the IMF requires. Increasing radicalism, demagogy, and anti-Western agitation may be the result. We must remember the evolution of Germany in reaction to the Dawes and Young plans of the 1920s, which were meant to finance German World War I reparations. That Germany’s national wealth was seen as being drained off to pay back foreign banks helped to create the climate in which Hitler took power in 1933.

It is this inherent contradiction between the measures needed to refinance the past and those needed to provide for the future the creates the greatest present challenge. The IMF, in exchange for financial assistance designed to restructure debt, demands that the countries it helps institute stringent anti-inflationary measures. It asks for currency devaluations to stimulate exports, reductions of local subsidies for foodstuffs and other products, less support for nationalized industries, and lower domestic budgets. These are difficult measures to implement in the best of times. In times of hardship, they are explosive. Several years ago Anwar Sadat tried to impose such a program in Egypt; the resulting social turmoil forced him to abandon the project. Recent speeches at the United Nations by the presidents of Brazil and Mexico referred rather ominously to the consequences of imposing austerity on third-world countries. The possibility that some among them may decide to default rather than accept the IMF’s demands should not simply be dismissed.

Along with recession, a dramatic contraction of world credit is taking place. Business Week recently estimated that a year from now no more than 100 big banks (down from 1,100 today) will be actively participating in large, syndicated loans to foreign countries. Jacques de Larosière, managing director of the IMF, recently pleaded with the banks not to withdraw from the international credit markets. The facts of life, however, dictate otherwise. As of the end of 1981, Fortune magazine reported the aggregate capital of the 100 largest banking companies outside the US to be $116 billion. This capital, together with the capital of US banks, is unlikely to be adequate to supply the domestic needs as well as the international credit requirements of today’s world. Unless concerted action is taken soon, the contraction in credit taking place right now will result in a further decline in international trade and in raw material prices and is likely to cause further deterioration in the already fragile international credit structure.

It will be most difficult to bridge this contradiction between the growing need for credit and its sharp decline. Only a process of close cooperation among Western governments and central banks, commercial banks, and international organizations will have any chance of success. Sizable new credits from the banking system, extensions of existing debts, temporary moratoriums—all these measures will be required. To carry some of them out may require government guarantees as well as the involvement of both national and international institutions. The private banks, alone, cannot carry the burden. If current economic conditions continue for a year or so many countries will not be able to afford the interest on their loans much less any part of the principal.

Any process intended to rescue both debtors and creditors must be carefully managed if it is to have a chance of success. In New York City, we were able to manage the process by gathering around the same table representatives of those institutions needed to provide a solution: the state, the city, the banks, the labor unions. On an international scale such collaboration would be far more difficult, but something analogous will have to be undertaken.

A conference of creditor nations should be called to discuss not only current problems but the new structures needed to manage long-term solutions to them. If the industrially developed world is to increase substantially the assets of the IMF, an executive committee representing these countries should have a greater say in IMF policy. This would not be to the liking of many third-world countries, but credit is a scarce commodity; it will be politically necessary for the West to keep greater control of it. To deal with international credit effectively, responsibility for different regions should be created. Western European countries should take the lead in working out refinancing plans for the debts of Eastern Europe; Soviet participation in such plans should be a sine qua non, since the USSR has been benefiting from loans to Eastern Europe while staying aloof from the problem of repayment. The US and Japan should take the lead in refinancing arrangements with Latin America. The Europeans and OPEC might have a major part in dealing with Africa and with nations in some other parts of the third world.

There is, unfortunately, no “solution” to this problem. Of the $500 billion in loans to the poorer nations from the Western banking system, much will never come back; or if it does, it will come back over a very long period indeed. The classic method for the repayment of such excessive credit was a combination of inflation and growth. Both have been replaced by Western economic strategies of fighting inflation through equally classic methods of retrenchment and stagnation. Something will have to give. It is quite possible that fundamental changes in some Western countries will come about. The inevitable government involvement required to keep some of the banks afloat could lead, in Canada for instance, to the nationalization of some banks as the only way to maintain confidence. The past may impose a heavy price for excessive credit but we have no pleasant alternatives to recognizing this.

3) The international monetary system must be re-examined. Since the demise of Bretton Woods we have replaced an international system based on fixed exchange rates—which posed many problems—with a system based on floating rates, with even greater problems. The wild fluctuations in foreign exchange rates, speculative raids on individual currencies, the uncontrolled growth of the Eurodollar market—all have contributed to worldwide inflation and destabilization. Cooperation among the US, Japan, and the Western European governments to synchronize economic policies geared to sound growth is now vital.

So are commitments by their respective central banks to cooperate in controlling movements of currency. The pound sterling in 1976 dropped by a third; by 1980 it had gone up 50 percent. In 1981, it dropped 20 percent in six months. During 1978 the yen gained 45 percent against the dollar and the deutsche mark 27 percent. They have both gone down dramatically since then. There should be clear and public commitments among the major central banks to maintain their respective currencies within specific limits as long as their respective governments maintain rational economic policies. One way to do this would be to expand the European monetary system to include the US, Japan, and possibly Canada. Such close cooperation is obviously inconsistent with the American sanctions against European governments and companies involved in the construction of the Soviet gas pipeline; it would certainly permit, however, negotiations aimed at tightening European subsidies, through cheap credit, of exports to the Soviet Union or anywhere else.

Such a program must also include a greater effort on the part of those who, until now, have not pulled their weight in providing credit and assuming risks: the Soviet Union in Eastern Europe; the larger OPEC producers in the third world. It also, quite clearly, requires policies more aggressively geared to growth, which is the only long-term remedy to the current disease. The risk of somewhat higher inflation levels has to be recognized and compensated for.

The importance of Bretton Woods can be seen in the deterioration of the international economic situation since its demise. The world is getting smaller and the stakes are getting larger; a new system must be put in place quickly.

It took fifteen years for New York City to come to the edge of bankruptcy: it took six years to work out the arrangements that avoided it. Many shared responsibility for the crisis: politicians, banks, unions, voters. All who created the problem participated in the solution. So it must be today. Our banking system is one of the most precious assets of our economy and of the free society itself. Recognizing the dangers facing it does not require us to engage in a witch hunt to allocate blame for a situation for which changing worldwide economic, social, and political conditions are as much at fault as anything else. The problem will not go away: its dimensions are too great. It has to be faced with cooperation, courage, and candor. If the Western governments together with their financial institutions can muster those qualities, then, with some luck and a great effort, a crisis in the banking system can be avoided during the coming decade.