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prepared to submit our findings and recommendauons to the Congress within 90 days. Meanwhile, the Board continues to support S. 71 as passed by the Senate, as well as additional provisions of H. R. 9450 introduced in October, 1977, by Congressman Allen. Among those provisions are restrictions on extensions of credit to insiders, including insiders at correspondent banks.
However, I am prepared to convey today the Board's preliminary reaction to the contents of the survey. In general, while the results raise questions about potential insider abuses, these dubious practices do not appear to be widespread or to involve quantitatively large commitments of available funds. Indeed, the aggregate dollar amount of the types of loans covered in the survey (bank stock loans, loans to insiders of the reporting bank and loan to insiders of other banks) represents only about 3 percent of the total loans at domestic offices of all commercial banks. In addition, it appears that the great majority of each of these three types of loans were made on something close to standard commercial terms, as indicated by the finding that over 90 percent of each type of loan carried interest rates at or above prime.
Moreover, it should be remembered that important and legitimate economic functions are served by most of the lending activities covered by the survey. Bank stock loans provide the means for the orderly transfer of bank ownership, especially in unit or limited branching states where nearly three-fourths of such loans were made. Loans collateralized by bank stock also represents a significant source of funding to augment bank capital. And although nearly 90 percent of the credit extended to insiders at the reporting bank represented loans to directors and their business interests, the vast majority of these loans probably represent normal commercial credits to customers ranking among the bank's best.
I would like to consider each of the four parts of the survey, review the potential problem areas that they addressed and discuss the Federal Reserve System's approach to dealing with these problems.
The first part of the survey focused on loans secured by bank or bank holding company stock. The primary objective was to determine whether insiders may have used the correspondent balance of their banks in order to obtain bank stock loans from other banks, possibly at preferential rates. Banks were asked to report data on each loan with a current balance of $25,000 or more if the lending bank held in the aggregate as collateral 10 percent or more of the outstanding voting shares of the banking organization whose stock was pledged on the loan. Less than 642 percent of the banks reported having such loans, and most of the loans reported were made by the larger regional and money center correspondent banks. About four-fifths of these loans were made to insiders—that is, executive officers, major shareholders, or directors—of bank or bank holding company whose stock was pledged.
The survey results raise the possibility of some insider abuse connected with bank stock loans. In 88 percent of the reported loans, the bank whose stock was pledged maintained a demand balance with the lending bank. Of course, the correspondent relationship may have been long established, predating the bank stock loan, or might have been entered into for reasons having nothing to do with the loan. In addition, the survey data indicate that insiders of other banks typically obtained lower rates their bank stock loans when a correspondent balance was maintained with the lending bank. The interest rate on bank stock loans was above 8 percent on only one-fifth of the fixed rate loans where balances were maintained, compared with more than one-half of such loans where balances were not present. Similarly, the interest rate was below 7 percent on 46 percent of loans when balances were maintained compared with only 18 percent when there were no such balances.
It is important to recognize, nevertheless, that the data do not provide conclusive evidence of more favorable treatment. The rate of interest is only one among several important terms and conditions of a credit transaction. Data on other factors such as origination date of the loan, the maturity of the loan, the creditworthiness of the borrower and the loan to collateral value ratio were not collected and could account for differences in rates. Moreover, it may be noted that for the bulk of the loans where a balance was maintained, there was no apparent relationship between the interest rate on the loan and the size of the balance. Thus, borrowers apparently did not receive lower rates by having their bank maintain a larger balance. Finally, the survey evidence indicates that bank stock loans were not often negotiated at rates below the prevailing prime rate. For example, during the most recent 1967-77 period, when 85 percent of the reported loans were originated or rolled over, less than 2 percent appear to have been made at below the average prime rate.
The second part of the survey dealt with all types of bank loans in excess of $10,000 (including mortgage loans of over $60,000), to insiders of other banks. Again, the prin.ary objective was to determine whether insiders may have used the correspondent balances of their banks in order to obtain loans from other banks, perhaps on more favorable terms. The evidence suggests that lower rates were sometimes received by these insiders when their banks maintained balances with the lending bank. For example, when a demand balance was maintained, the weighted average rate for fixed rate loans was 7.58 percent, compared with 8.47 percent for loans when a balance was not maintained. For all reported floating rate loans, when a correspondent balance was maintained the weighted average rate for loans was 7.72 percent, versus 8.21 percent for loans without a balance. Again, care must be taken in interpreting these rate comparisons. The differences on average are not particularly large, and may reflect other factors on which information was not collected as part of the survey.
It should be pointed out that the maintenance of correspondent balances is a necessary, long established practice in the banking system that ordinarily represents a mutually beneficial arrangement for the banks involved. For example, smaller banks typically maintain demand balances with regional or money center correspondents to compensate the latter for the provision of a wide variety of services such as check clearing deposit accounting and investment advice. Given a continuing close relationship of this nature between banking organizations, which generally necessitates frequent contact between their senior personnel, it is only natural for officials of the smaller bank to seek accommodation at the correspondent bank. The correspondent's lending officers typically will now the borrower very well, and in those cases where the stock of the smaller bank is pledged, they will be familiar with the condition of the bank.
Nonetheless, the Board has recognized for some time the possibility of abuse in the placement of correspondent balances and has taken a number of measures to limit such abuse. As you know, the Federal Reserve received a letter in September, 1970, from the Justice Department citing the inappropriate use of correspondent balances for the personal benefit of bank officials. The views of the Justice Department and the concern of the Board of Governors on this matter were coveyed to each State member bank in a letter from Chairman Burns on October 26, 1970. It was indicated that the practice of using interbank deposits as compensating balances for loans to individuals connected with the depositing bank could warrant prosecution in certain situations.
Since 1967, the Federal supervisory agencies have been exchanging information developed during examinations on loans to officers of other banks and loans secured by stock of other banks. All reports of loans to officers of State member banks received from the other agencies are verified at subsequent examinations of the banks where the officers are employed to determine compliance with section 22(g) of the Federal Reserve Act and the Board's Regulation 0. The examiners were further instructed in 1973 to expand their verification of these reports to include, among other things, a determination of whether more favorable interest rates were being obtained and whether correspondent balances held with the lending bank were commensurate with the services provided.
Our concern about potential abuses in the granting of bank stock loans or loans to executive officers also has been reflected in several public statements issued in connection with bank holding company applications. In each application for approval to form a bank holding company or to acquire an additional subsidiary bank, the Board requires disclosure of any indebtedness collateralized by the bank's stock, including an indication of any changes in correspondent balances or a description of any agreement or understanding concerning correspondent balances. The purpose of this requirement is to determine whether bank credit is being obtained on a basis that encourages or rewards the improper use of interbank deposits. The Board considers the existence of more favorable loan terms in connection with the placement of a bank's correspondent account as an adverse managerial and banking factor in acting on holding company cases.
Similar disclosure is required in the annual reports that bank holding companies must submit to the Board. All of this information is reviewed and taken into consideration by the Federal Reserve in its regulatory and supervisory actions regarding bank holding companies. in some instances, we have been able to detect and to eliminate preferential interest rates on loans collateralized by bank stock. However, the determination of abuse regarding correspondent balances is more difficult in view of the numerous services that can be rendered to justify the balances.
The third part of the survey dealt with loans by banks to their own insiders. The primary objective was to determine whether insiders may have received preferential rates. Banks reported $10 billion of such loan, of which nine-tenths had been made to directors of the bank or their business interests. It is difficult to interpret the significance of this finding because bank directors are frequently recruited from
among a bank's best customers. Thus, a loan relationship with a director's outside business may well predate his appointment to the bank's board. In other words, a substantial proportion of these loans probably would have been made regardless of any “insider” relationship.
The survey results show that the average rates paid by insiders were generally above the prime rate, that is, the rate charged by large banks to their most creditworthy customers. For example, for the fixed rate loans made to insiders at the reporting bank during the third quarter of 1977, the average rate was 8.07 percent, compared to an average prime rate during that quarter of 6.90 percent. On fixed rate loans made to insiders during the first half of 1977, the average insider rate was 8.29 percent, well above the average prime rate of 6.36 percent. The average insider rate was significantly below the average prime rate only for loans originated in 1974. This was an abnormal year in that the prime rate rose precipitously during the year to a record high. Many smaller banks do not closely follow the large bank prime rate in pricing their loans, which could account for some of the reported loans having been made at rates below prime in that year.
In the Board' view, the survey data do not seem to suggest any widespread abuse involving insider loans. In part, this may reflect enforcement efforts under section 22 of the Federal Reserve Act, which places tight limitations on the types and amount of loans a member bank can make to its own executive officers, and prohibits terms on such loans that are more favorable than those afforded other borrowers. Last year, the Senate approved legislation that would extend and strengthen the restrictions of section 22. One of the provisions adopted in S. 71 would prohibit a commercial bank from making a loan to any officer, director or 10 percent shareholder, or to any company controlled by such parties, unless such loan was made on substantially the same terms as those prevailing for comparable transactions with other persons. In addition, such insider loans could not involve more than normal credit risk, and could not contain other features unfavorable to the bank. As you know, the Board strongly supported S. 71 and hopes that it will be enacted by the Congress this year. Such legislation should go far in protecting banks from abuse from insider lending.
The final part of the survery dealt with overdrafts by insiders of the reporting bank, insiders of other banks and public officials. The objective was to determine whether there were significant abuses associated with these overdrafts. The survey showed that two-thirds of the reporting banks had no overdrafts exceeding $500 to any of their own insiders at any time during the first nine months of 1977. More than 90 percent of the banks had no overdrafts over $500 during that period to insiders of other banks or to public officials.
However, two findings deserve comment. First, there were reports of isolated cases of very large overdrafts, mostly to insiders of the reporting bank. These overdrafts may have been of very short duration or may have been offset by other accounts held at that bank, but they deserve further investigation. Second, a large proportion of the banks reporting overdrafts to their insiders indicated that they always or frequently waive overdraft charges. The fact that charges are waived much more frequently for insiders of the reporting bank than for insiders of other banks and public officials suggests also that there is a more favorable treatment of the former group than of the general public.
It should be noted that overdrafts are considered to be unsecured extensions of credit and are included in the limits on loans to executive officers of member banks under section 22(g) of the Federal Reserve Act. Such loans are limited to a maximum of $5,000. We will, of course, take into account these survey results in order to ensure in the course of our examinations that there is full compliance with this statute.
In summary, the survey finding do not appear to indicate any pervasive pattern of more favorable treatment for insiders at commercial banks. The real possibility of a significant incidence of questionable practices, however, has been brought to light. These will have to be considered carefully on a case-by-case, bank-by-bank basis before any firm conclusion of abuse is warranted. But if the suggestion of improper practice is validated, supervisory action will be taken. Such action, scaled appropriately to the indicated violation, could be more readily and flexible applied if S. 71 were to become law.
The CHAIRMAN. Well, gentlemen, I want to thank you very much. You come together and you fall apart both in these recommendations.
Let me indicate where I think you're apart because you are very familiar, as we all are, of where you are together.
Mr. Heimann says, “However interpreted, the results of the survey are disappointing. They do reflect a level of preferential treatment of bank insiders.” Mr. Partee says, "In summary, the survey findings do not appear to indicate any pervasive pattern of more favorable treatment for insiders of commercial banks." And Mr. LeMaistre_says, “The survey represents a substantial undertaking by the Federal banking agencies and one which I feel provides some valuable insights into the dimensions and characteristics of insider lending and overdraft policies at commercial banks." It's hard to say where you come down. You may be in the middle there.
I'm kind of puzzled by this. It's been suggested that I ask if the real bank regulator will stand up. It's also been suggested that if you were in charge-if you three men were in charge of the Ten Commandments we would have 30 commandments. At any rate, there does seem to be some difference, but I'd like to get in now to the first of the similarities.
You unanimously support S. 71. All of you call for that. As you know, the Senate has acted on it and I agree with you wholeheartedly that it's a bill that should be enacted as promptly as possible by the Congress, but I'm surprised and concerned about your general interpretation of the results of this special survey.
I look at the results and see facts that indicate instances of preferential treatment given to bank insiders. At least Mr. LeMaistre and Governor Partee look at the results and see some suggestions of this, but I would interpret from your remarks that you think it's not widespread enough to be alarmed at. There's no reason that I know of that would suggest that we should be complacent about any preferential treatment given to bank insiders over that which ordinary citizens have access to, any more than the notion that only 1 car in 20 goes through a red light at 30 miles an hour should make us feel comfortable because it's only 1 out of 20 after all and 19 out of 20 are law abiding.
Let's go over some of the results of the survey. I'd like to know the reaction each of you has in each case.
First, the bank stock loan section. That is the section on making loans with bank stock as collateral. The results of the survey indicate that interest rates charged on loans where correspondent balances were maintained in the lending bank were lower than were the interest rates charged when no balances were maintained.
Do you consider this evidence of preferential treatment, Mr. LeMaistre?
Mr. LEMAISTRE. Yes, sir, I consider that some evidence of perferential treatment, but I do not consider it to be abusing the preferential status unless something else occurs. The fact that you get a lower rate doesn't necessarily mean you have done anything detrimental to your bank as an insider. It may be that the business that this particular insider brings to the bank more than compensates them for this treatment. It is itself evidence of preferential treatment. It should be looked at, but I don't think it should be prohibited.
The CHAIRMAN. I'm a little puzzled. You say it is preferential but not necessarily abusive?
Mr. LEMAISTRE. That's right.
The CHAIRMAN. So you say preferential treatment can be proper and ethical provided there's some other justification for it? Mr. LEMAISTRE. It may even be beneficial.
The CHAIRMAN. I'm puzzled by that. You indicate in your statement that a loan could be below the prime rate and not be abusive either. Under what circumstances? Because somebody brings in more business?
Mr. LEMAISTRE. The more obvious circumstance would be in Alabama where we have an 8-percent commercial lending rate by law. If the prime rate goes to 10 percent every loan in the bank is below the prime rate.
The CHAIRMAN. Of course, under those circumstances, but where you don't have a legal provision or legal law, would you still say that the loan below the prime rate is not preferential but it is preferential but not abusive?
Mr. LEMAISTRE. I would still say it's preferential, not necessarily abusive.
The CHAIRMAN. And under what conditions, except for that example you just gave?
Mr. LEMAISTRE. Let me give you another example. If you have $200,000 cash surrender value of life insurance and a bank is not at the moment getting any great demand for loans, it has excess cash which it must either sell or put into the market somewhere else. If it comes to the person who has this readily exchangable entity that is the cash surrender of life insurance he'll say, "I'll let you have money a little below the prime if you need it, if you pledge that insurance cash value.” The bank benefits by getting a little more than it will in the open market. The man who has that asset benefits by getting something at less than the going rate. But neither one of them has been hurt.
The CHAIRMAN. Well, I just wonder. How about other borrowers? How about the borrower that has to pay the prime rate? How about the stockholders of the bank? Do you think under those circumstances that that discrimination is justified because of the benefit that the bank gets?
Mr. LEMAISTRE. If the bank's investment opportunities were limited so that they would not have this opportunity to make that particular rate even though it was below the prime, it would certainly be beneficial to the bank to make the lower-rate loans.
The CHAIRMAN. All right.
Mr. Heimann, let me ask you—and of course, I don't want to get away from my initial question, which was related to bank stock loans and whether or not the rate below the usual rate is provided for those who have correspondent balances.
Mr. HEIMAN. Mr. Chairman, I agree with Mr. LeMaistre that a loan may be preferential but not abusive. That transaction has to be looked at in the full light of what it is, the collateral that has been pledged and a whole host of other circumstances.
Clearly, in different parts of the country at different times the loan demand varies. You might have in one section of the country a sufficiency of funds or an excess of funds in a bank where a specific loan might prove to be a very good loan for a short period of time. Our own view on this is that that a singular transaction must be looked at in its own institution in light of the then current
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