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By Bruce W. Leppla

e are all aware of the

growing strains on bank profitability: declining loan quality, slow deposit growth. and loss of market share to nonbank competitors. With these changes underway. bankers must look ahead and aggressively pursue their markets.

I think it's clear that banking's future profitability lies not simply in fee income or improved loan quality, but in the generation of deposits. Fees from trust management, real estate transactions, and other services are important but are not unique to banks. Loan generation and loan quality have recently become important issues, however these areas can be addressed assuming that the fundamental problem in our business--that is. the rising cost of funds and corresponding decline in net interest margins-is addressed. In my view, the problem that deserves the most attention from bankers and from Congress is the growing inability of banks to generate and retain deposits at reasonable

rates.

As we know, there has been a hemorrhage of bank deposits. The commercial banks' share of total deposits declined from 60 percent to 30 percent between 1940 and 1980. Whole generations of bank customers have learned to find competitive rates and terms at thrifts and other nonbank institutions. Our consumers, and our markets, have run from us.

Banks have fared badly on the deposit side in recent years for very good reasons. We have a well-managed insurance fund --the FDIC--but that in turn requires a 6 percent capital-toasset ratio that is double that of our competitors in the thrifts. Under our current regulatory environment, it is apparent that commercial banks simply cannot offer the same rates as less capitalized, less insured competitors. Less leverage, and less margin means that we are

less attractive to capital partners, and, for that matter, to future generations of competent management.

Banks are also restricted from certain securities activities that our nonbank competitors have exploited well. These limits on commercial bank activity are well known. Commercial banks are unable to securitize loan assets, particularly consumer receivables, and are thus prevented from renewing our loanable funds. We are unable to offer our regular retail customers mutual

"Many banks would prefer to work in alliance with a local or regional brokerage house, relying on its expertise and economics of scale."

funds. even though banks successfully manage trusts and ERISA accounts, and can provide mutual fund clones (e.g.. collective investment trusts) to IRA and Keogh customers. Banks are unable to underwrite industrial revenue bonds or even to invest in taxexempt industrial development agency bonds. Because banks cannot underwrite and sell commercial paper, our biggest and best commercial borrowers are being serviced by the brokerage houses.

From the customer's point of view, "financial services" are now available at brokerage houses. savings and loans, and commercial banks. At a brokerage house the customer can trade securities, save in Treasury bills or mutual funds. and purchase life insurance. From a savings and loan. the customer can obtain insurance and all kinds of real estate financing. While commercial banks can offer a full array of loans and, most importantly, FDIC-insured deposits, let's look at the evidence: these

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facilities are important to

consumers, but obviously are not in themselves enough to attract and hold deposits. Who among us will not admit that, compared to bank deposit products, the Merrill Lynch Cash Management Account or the Dean Witter Reynolds Active Asset Account, are more attractive--they offer competitive rates and, more importantly, considerably more investment flexibility.

We need to remember that our customers, just like the Congressmen they elect, have difficulty distinguishing a "bank" from other "financial service" entities. While bankers can understand the functions of bank subsidiaries within bank holding companies, our increasingly sophisticated customers, and potential customers, see only interest rates and service features.

It is no wonder many customers are attracted to the brokerage houses and savings and loans. Together they can accomplish what bankers would hope to deliver--short and long term investment instruments, a menu of retai!

loans and, increasingly, "quasi"

commercial loans. As customers develop their understanding of finance, many want to diversify their assets to include less liquid, higher risk stocks, bonds, and real estate.

We need access to the securities business in order to hold customers who might otherwise be lost to a mutual fund. We need to be able to offer consumers the kind of one-stop financial convenience and expertise we provided before the revolution in finance and information.

Not every bank may want to become a securities house that could trade for clients directly.

Bruce W. Leppla is president and chief executive officer of Redwood Bank in San Fran. cisco. Organized in 1962 as the Redwood National Bank. Redwoud is a state-chartered independent bank with four branches in the Bay Area with toal assets of approximately $120 million. Leppla joined Redwood Bank in 1983.

Many banks would prefer to work in alliance with a local or regional brokerage house. relying on its expertise and economies of scale. The income derived from the securities relationship would be supplemented with the cross-marketing advantage of offering these consumers other, more traditional bank services.

The banking law just passed by Congress is another example of lost opportunities for the independent banker. While the bill closed the much-debated nonbank bank loophole. it imposes a renewable one-year moratorium on all new securities powers for banks. If this moratorium is as "temporary" as Regulation Q was during the 1960s and 1970s. banks for the forseeable future will not be able to penetrate the monopolies so tightly guarded by the securities industry.

The issue of nonbank banks has been a divisive one that we should put behind us. We need to focus our energies not on trying to squeeze the nonbank bank genie back into the bottle, but instead to learn the same magic and compete in the same markets.

By Carrol R. Pruett

There exists among our federal legislators and regulators a mistaken belief that allowing commercial banks to engage in real estate development and investment would somehow endanger the safety and soundness of our banking system.

Nothing could be further from fact! Here in California, this type of activity has been permitted for state chartered banks since January of 1984. Although there has not been a stampede of banks to adopt the new powers, those utilizing them find real estate activities to be good for the bank in terms of profitability, good for the consumer in terms of benefits, and generally good for the economy.

Mid-State Bank was among the first in California to utilize

|“If a bank or project is in trouble, regulators know and can act."

the real estate development and investment powers in 1984. These investments have proven to be very profitable. generating an average return of 25-30 percent for the past two years. Outside the state, many Midwestern bankers credit their survival since 1980 to their real estate and insurance income.

Our bank entered this activity for several reasons, including these three:

•Loan demand was declining from increased nonbank competition;

•Profits were being squeezed as rate margins were shrinking: and

• Our bank. like most banks. had a lot of experience in construction lending activities.

When considering these basic facts, it was our opinion that real estate investment and development was a natural

"Most of our projects are done on a joint venture basis with local bank customers who are pleased to have an experienced financial partner."

extension of our traditional lending activities, and that managing the risks of each was very similar in nature. In fact, we use our same basic credit ground rules, which are "Don't lend (i.e., invest or build) out of your service area," and "Know your borrower (i.e., developer or partner)." We find that we also exercise greater daily control over the fate of an investment than over a loan.

Most of our projects are done on a joint venture basis with local bank customers who are pleased to have an experienced financial partner. Many of our partners are those

talented but less well-established contractors or developers who are not yet able to syndicate their own projects.

While our bank moved into these activities early on, there are many banks that have hesitated. Of the 287 state chartered banks in California, 100 have received approval to engage in real estate development and investment; of these, only 63 are active as of December 31, 1986. and only in the amount of $99.9 million. That amount represents approximately 0.1 percent of the total assets of all state chartered banks, and only 1 percent of the total assets of the aforementioned banks, according to the California State Banking Department. This is a good indicator that commercial banks are moving with prudence and caution.

Having read the horror stories of savings and loan

failures, many Congressman and federal regulators worry that banks would experience the same results. In my experience and opinion, this is not likely. I maintain that the difference is very clear indeed: the thrift experience showed a very clear lack of supervision by regulators, as well as a lack of restraint on the level of thrift investment. This is illustrated by the abusive insider dealing among some troubled thrifts. It is important here to point out that thrifts also have far lower capital standards than banks, another weakness in their experience.

I can also tell you that in California the experience has been positive because we do have clearly defined supervision and regulation of the banks that have sought and received permission to become active in real estate development and investment. Whereas thrifts appear to have been allowed to invest up to 100 percent of total assets in real estate projects. California state chartered banks, by contrast, can invest no more than 10 percent of total assets, or 100 percent of shareholder equity, in real estate projects. Additionally, our activities

"Experience demon

strates that real estate investment and development are merely other forms of real estate lending."

are reviewed frequently as part of the ongoing examination process, where each project receives the same thorough scrutiny as any loan being examined. If a bank or project is in trouble, regulators know and

can act.

While the California experience has been highly favorable and numerous national banks

Carrol Pruett is president of Mid-State Bank in Arroyo Grande, an institution with $450 million in assets as of December 31. 1986. Pruett is also a former CBA President.

would like to enter this new investment area. now they cannot. Why? Effective March 1. 1987, a federal moratorium was put in place that precluded any new entries into what are considered nonbank activities.

This moratorium is scheduled to expire March 2, 1988. We bankers should be working with our federal legislators now to see that this moratorium is not extended or that any similar new controls are put in place.

California bankers have proven that expanded real estate powers are a natural extension of traditional banking functions. Surely no one can disagree with the idea that real estate lending is a "normal" banking activity. Experience demonstrates that real estate investment and development are merely other forms of real estate lending.

In this environment of deregulation for the nonbank financial entities and re-regulation of commercial banks, our future depends on our ability to compete in the marketplace. The ability of all banks to engage in real estate investment and development is one more opportunity to offer a product that is beneficial to all.

By Jerry Henley

That a just service our legislators could

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provide to rural com

munities and their small banks if they took a thoughtful look at the current need for banks to issue securities.

Many unincorporated areas, like the one I live in, have special districts for hospitals, fire, water, sewer, recreation, airports and economic development. These community services are in a constant state of growth and renewal, and require long-term repayment on their debt securities.

Communities of rural America could benefit substantially if banks were allowed to underwrite securities and offer mutual funds, and banks could benefit from having the new business opportunities they need to remain financially healthy.

Currently, only the largest of these special districts can obtain underwriting from securities dealers at reasonable terms and rates. Many rural communities have several well-run, smaller special districts that are virtually ignored when the regional brokerage houses have bigger, better deals to underwrite elsewhere. The same advantages could also be expected in incorporated cities on smaller issues of underwriting.

In an effort to keep a renewable source of funding available to the community and its citizens, it is difficult, if not impossible, for the small bank to provide enough long-term loans out of its own portfolio to serve all of the debt needs of these local special districts.

And who has a better understanding of these local needs than the local bank? If the community lacks growth or cannot provide services, then the local banks are also jeopardized, which has happened in a number of communities.

In California, banks can ac

quire district bond issues for their own investment portfolios, yet are prohibited from underwriting these smaller issues. What could happen if banks do not obtain securities powers? Let me point out three communities that no longer have banks, and explain why.

Near my community of Truckee are the towns of Downieville, Loyalton and Kings Beach, all of which had banks two years ago. Today, none of these towns has a bank. There is little or no recycling of local customer wealth for the needs of these communities; therefore, no interested lender or local underwriter is available to assist in maintaining local prosperity.

Because banks cannot offer

"Local government districts could receive special attention and an underwriting opportunity locally, where they are best understood."

securities/investments and other diversified financial products and services, there is not enough banking business to support a branch office. As a result, these three isolated communities now have fewer services than before.

If our bank could underwrite securities and securitize our loans, we could provide important benefits for our customers. our special districts and our bank. including:

1. Local government districts could receive special attention and an underwriting opportunity locally, where they are best understood.

2. Within the area, customers' wealth could be invested in

local bonds to keep their money working locally--much more than is currently allowed. 3. The bank would prosper in improved community relationships and thereby keep additional profits--additional investment capital--within the community.

4. Overall growth would occur in the bank, the special services district, and the community at large to increase the job opportunities needed in rural

areas.

5. The bank could retain most of its deposits for additional lending to local citizens and businesses by providing a greater menu of services to existing customers.

In addition, if our bank could offer a variable rate U.S. Government securities mutual fund to customers, this would increase our fee income while helping customers. Bankers are generally more concerned with a customer's risk taking, and rural customers generally lack personal access to stockbrokers.

Some rural small barks might question the cost of underwriting mutual funds, considering their limited market share and the cost of experienced people familiar with industry rules and regulations. Large banks have these capabilities, however, and could serve in their normal correspondent banking relationships to offer security transactions to small banks.

Alternatively, several small banks could jointly form a bankers' bank--a management company, to operate mutual funds and underwrite securities-spreading the cost of such operations over a larger customer network and sharing the fee income. Bankers' banks have been formed for various purposes in several states.

Such an arrangement serves the customer professionally, efficiently, and conservatively, offering lower-risk mutual

Jerry Henley is Chairman & CEO of Truckee River Bank, a Lake Tahoe-area institution with $85 million in assets.

funds to preserve customers' wealth: a traditional banking standard. Banks would protect long-standing relationships with valued customers by not being overly aggressive in their advice.

In today's high-tech aggressive world of marketing, and because of the highly restricted form of preserving customer and community wealth, it is becoming ever more difficult for banks to preserve and hold deposits. Failure to change our financial system is furthering the decline in the strength of our rural economies.

The closure of the three banks I mentioned earlier is a prime example of why additional diversified services are needed for banks. Had they been able to serve the same customers with additional needed products and services, those banks would have had sufficient income to continue to be active community participants.

The partial and lagging deregulation of banks is increasingly a disincentive to engaging in banking in rural America. To help our rural economies, we need additional tools to restore the vigor and growth all banking once had.

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