[Senate Hearing 107-504]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 107-504


                          THE CONDITION OF THE
                          U.S. BANKING SYSTEM

=======================================================================

                                HEARING

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED SEVENTH CONGRESS

                             FIRST SESSION

                                   ON

THE EXAMINATION OF ISSUES RELATED TO THE CONDITION OF THE UNITED STATES 
 BANKING SYSTEM, INCLUDING THE EFFECTS OF THE SUGGESTED DETERIORATING 
 BANK ASSET QUALITY, AND IMPROVED RISK MANAGEMENT AND CONTROL SYSTEMS 
             NEEDED TO RESPOND TO CHANGING ECONOMIC EVENTS

                               __________

                             JUNE 20, 2001

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


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                            WASHINGTON : 2002
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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  PAUL S. SARBANES, Maryland, Chairman

CHRISTOPHER J. DODD, Connecticut     PHIL GRAMM, Texas
JOHN F. KERRY, Massachusetts         RICHARD C. SHELBY, Alabama
TIM JOHNSON, South Dakota            ROBERT F. BENNETT, Utah
JACK REED, Rhode Island              WAYNE ALLARD, Colorado
CHARLES E. SCHUMER, New York         MICHAEL B. ENZI, Wyoming
EVAN BAYH, Indiana                   CHUCK HAGEL, Nebraska
JOHN EDWARDS, North Carolina         RICK SANTORUM, Pennsylvania
ZELL MILLER, Georgia                 JIM BUNNING, Kentucky
                                     MIKE CRAPO, Idaho
                                     DON NICKLES, Oklahoma

           Steven B. Harris, Staff Director and Chief Counsel

             Wayne A. Abernathy, Republican Staff Director

                  Martin J. Gruenberg, Senior Counsel

                         Aaron Klein, Economist

           Sarah Dumont, Republican Professional Staff Member

                Linda L. Lord, Republican Chief Counsel

   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                       George E. Whittle, Editor

                                  (ii)


                            C O N T E N T S

                              ----------                              

                        WEDNESDAY, JUNE 20, 2001

                                                                   Page

Opening statement of Chairman Sarbanes...........................     1
    Prepared statement...........................................    46

Opening statements, comments, or prepared statements of:
    Senator Gramm................................................     2
    Senator Johnson..............................................     3
    Senator Shelby...............................................     4
    Senator Reed.................................................     4
    Senator Allard...............................................     5
    Senator Corzine..............................................     5
    Senator Bunning..............................................     5
    Senator Dodd.................................................     6
    Senator Bayh.................................................    17
    Senator Schumer..............................................    36
    Senator Carper...............................................    39

                                WITNESS

Alan Greenspan, Chairman, Board of Governors of the Federal 
  Reserve System, Washington, DC.................................     7
    Prepared statement...........................................    46
    Response to written questions of Senator Sarbanes............    79
    Response to written questions of Senator Ensign..............    92
John D. Hawke, Jr., Comptroller of the Currency, U.S. Department 
  of the Treasury, Washington, DC................................    10
    Prepared statement...........................................    54
    Response to written questions of Senator Sarbanes............    94
Donna Tanoue, Chair, Federal Deposit Insurance Corporation, 
  Washington, DC.................................................    12
    Prepared statement...........................................    64
    Response to written questions of Senator Sarbanes............   105
Ellen Seidman, Director, Office of Thrift Supervision, U.S. 
  Department of the Treasury, Washington, DC.....................    14
    Prepared statement...........................................    70
    Response to written questions of Senator Sarbanes............   119

                                 (iii)

 
                         THE CONDITION OF THE 
                          U.S. BANKING SYSTEM

                              ----------                              


                        WEDNESDAY, JUNE 20, 2001

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Committee met at 10:05 a.m., in room SD-538 of the 
Dirksen Senate Office Building, Senator Paul S. Sarbanes 
(Chairman of the Committee) presiding.

         OPENING STATEMENT OF CHAIRMAN PAUL S. SARBANES

    Chairman Sarbanes. The Committee will come to order. I am 
very pleased to welcome this distinguished panel of witnesses 
before the Banking, Housing, and Urban Affairs Committee this 
morning: Alan Greenspan, the Chairman of the Federal Reserve 
Board; Jerry Hawke, the Comptroller of the Currency; Donna 
Tanoue, the Chair of the Federal Deposit Insurance Corporation; 
and Ellen Seidman, the Director of the Office of Thrift 
Supervision.
    The purpose of today's hearing is to review the condition 
of the banking system of the United States. The witnesses have 
been asked to testify regarding the safety and soundness of the 
banking industry and its impact on the economy, as well as any 
potential problems they foresee facing the financial services 
industry.
    It has always been a charge of this Committee to concern 
itself with the safety and soundness of the financial system, 
which is, after all, fundamental to the effective functioning 
of our economy. In fact, the safety and soundness of the 
American financial system has been one of the strengths of our 
economic system in comparison with many other countries around 
the world.
    This hearing is not prompted by any triggering event or 
problem. Rather, it is our intention to have a practice of 
holding periodic oversight hearings on the state of the banking 
system. By making this a regular event, we would hope to 
elevate scrutiny of the system when times appear to be good and 
there may be a tendency toward complacency, as well as to 
diffuse potential alarm when a hearing is held at a time when 
problems may exist. We would hope that such periodic hearings 
would be a useful discipline on the system and perhaps serve as 
a stabilizing influence.
    It appears that the past decade of economic growth has 
significantly strengthened the condition of the U.S. banking 
system. It is my own view that enactment by Congress of the 
Financial Institutions Reform, Recovery, and Enforcement Act, 
FIRREA, of 1989, in response to the thrift crisis, and the 
Federal Deposit Insurance Corporation Improvement Act (FDICIA), 
of 1991, in response to the commercial banking problems of the 
late 1980's and early 1990's, made a contribution to that 
improved condition. The capital and regulatory standards put in 
place by those statutes helped the system to take advantage of 
the growing economy of the 1990's. The improved coordination of 
supervision by the regulators has made a substantial 
contribution and we are encouraged to see the increased 
coordination that is taking place amongst the regulators. We 
think that is a very positive development.
    This morning, we will hear from the regulators that the 
banking industry is better situated today to withstand the 
softening of the economy than it has been in the past. Banks 
have a greater variety of products and more geographical 
diversification in their assets. They have higher earnings, 
more capital, better risk-management techniques, and higher 
asset quality than in the past. Nevertheless, problems do exist 
and there are some trend lines that I think are of some 
concern.
    Asset quality has degraded over the past 2 years and loan 
loss provisions have increased substantially. Noninterest 
income of banks has been affected. And net interest margins 
have declined. The manufacturing sector has also been slowing 
down, which affects commercial loan quality. Mounting employee 
layoffs adversely affecting consumer loan quality. And 
consumers are more highly leveraged today than any other 
measured point.
    The Committee will want to review all of these issues with 
the regulators this morning. Mainly, we want to get an 
assessment not only of how the system looks today, but also how 
it may look 6 months or a year from now. The consensus forecast 
is that economic growth will pick up in the third and fourth 
quarters of this year and resume at a faster pace next year. If 
this happens, one can assume it will have a beneficial impact 
on the banking system.
    But we need to have some sense of how well equipped the 
system is to cope with a weak economy, as well as a growing 
economy. And we want the regulators to lay out for us not only 
how they see the landscape, but also any recommendations they 
have which would help to improve or ensure the safety and 
soundness of the financial system. So, I want to welcome our 
four distinguished witnesses.
    I yield to the Ranking Member, Senator Gramm.

                 COMMENTS OF SENATOR PHIL GRAMM

    Senator Gramm. Well, Mr. Chairman, first, let me thank you 
for this hearing. I cannot think of a more important issue for 
the Committee to concern itself with than oversight of the 
greatest banking and financial system in the history of the 
world.
    We have gone through a slowdown and readjustment and, to 
some degree, to quote a famous oracle: ``Seen the end of, 
irrational exuberance, in the equity market. Anything 
irrational ultimately has to come to an end.''
    I hope and believe that the American economy is still 
fundamentally sound. If the consensus projections are right, 
many of these indicators should be improving even as we have 
this meeting, but oversight is always a good thing.
    I want to congratulate you, Mr. Chairman, on your 
leadership in this area. I want to thank our regulators, 
especially those who are leaving at the end of a tenure which I 
believe they can be proud of. I look forward to hearing, them 
and from having an opportunity to ask questions. Thank you.
    Chairman Sarbanes. Very good. Thank you.
    Senator Johnson.

                STATEMENT OF SENATOR TIM JOHNSON

    Senator Johnson. Thank you, Mr. Chairman. I cannot think of 
a more appropriate hearing than to have this hearing today, 
taking a look at the four bank and thrift regulatory agencies 
under our jurisdiction on the condition of the U.S. banking 
system, as your first hearing as Chairman of the Banking 
Committee during this 107th Congress.
    I want to thank the panel members for joining us today and 
Senator Gramm for his excellent leadership during the unusual 
course of events that have occurred the past year during this 
Congress.
    Clearly, the banking industry is in overall excellent 
condition at this time. They have earned a record $19.9 billion 
during the first quarter, exceeding the previous record set in 
2000. This year marks the eighth consecutive year in which 
banks earned a return on investment in excess of 1 percent. 
Prior to 1993, the industry never had an ROA in excess of 1 
percent. So these have been remarkable times in many ways.
    Nonetheless, there are points of concern during a time of 
economic slowdown where asset quality problems have worsened 
over the past 2 years and loan loss provisions have increased, 
margins have come down, in part because of more competition 
from a wide variety of bank and nonbank lenders. Loan losses 
have continued to rise and bank deposits have not increased as 
quickly as bank loans. I believe that the condition of the 
banking industry is indeed solid, in large measure due to the 
regulatory oversight of the individuals before the Committee 
today.
    As the new Chairman of the Financial Institutions 
Subcommittee, I have a particular interest in the deposit 
insurance system. And I applaud Ms. Tanoue on her leadership at 
the FDIC and all that she has done there. I have appreciated 
their recommendations on FDIC's reform. It is difficult to 
argue with the FDIC's observation that the current system is in 
fact pro-cyclical. That is, in good times, most institutions 
pay nothing for insurance coverage. And in bad times, when they 
can least afford it, institutions potentially can be hit with 
huge premiums. At the same time, insured deposit limits have 
not kept pace with inflation. I am also concerned about 
significant inflows of insured deposits into the system and the 
impact that this has had on deposit reserves.
    These are difficult issues. And I look forward to working 
with the regulators, industry groups, and consumers to develop 
a sensible, fair reform approach. I have had an opportunity now 
to engage in some discussion with Chairman Sarbanes and I look 
forward to the possibility of holding hearings in the Financial 
Institutions Subcommittee on the FDIC's reform proposal. We 
should be able to have a comprehensive deposit insurance bill 
put together in a bipartisan consensus fashion, hopefully after 
the July 4 recess.
    So, again, Mr. Chairman, thank you for holding this hearing 
and I look forward to working with you and with Ranking Member 
Gramm closely on our agenda over the remainder of this year.
    Chairman Sarbanes. Thank you very much, Senator Johnson.
    Senator Shelby.

             COMMENTS OF SENATOR RICHARD C. SHELBY

    Senator Shelby. Thank you, Mr. Chairman.
    I want to thank you for calling this hearing. It is very 
important for this Committee to be holding a hearing on the 
condition of the banking system.
    The banking system plays a crucial role in the development 
of the American economy. While I believe the market--the 
initiative and efforts of individuals and firms--provides the 
fundamental driving force behind the success and the strength 
of the American financial system, I recognize that we have 
adopted some regulatory safeguards from such market forces. 
These measures are intended to temper instability in the 
banking system that could have devastating effects on the 
overall economy.
    This hearing, Mr. Chairman, provides us with an excellent 
opportunity to consider the performance of the regulatory 
framework that we have put in place. It is my hope that the 
Committee adopts a balanced approach today and closely 
considers both regulations that protect the integrity of the 
system, as well as those which are ineffective, overly 
burdensome, and weaken banking institutions.
    I look forward to the testimony from today's witnesses and 
I commend you for calling the hearing, Mr. Chairman.
    Chairman Sarbanes. Thank you very much.
    Senator Reed.

                 COMMENTS OF SENATOR JACK REED

    Senator Reed. Thank you very much, Mr. Chairman. Again, let 
me commend you and the Ranking Member for holding this hearing 
today. I think it is important to get an oversight of the 
status and the health of the banking system. And from your 
comments and my colleagues' comments, the system is generally 
healthy.
    But it is a system that has been changing dramatically over 
the last several years--significant consolidations, blurring of 
lines between traditional financial institutions. This is a 
very appropriate time to make an assessment of the status, the 
health, and the future of the banking system.
    It also gives us an opportunity to put in context specific 
issues that we will deal with as we go forward--continuation of 
discussions about financial privacy that began under the 
auspices of the Gramm-Leach-Bliley debate. As Senator Johnson 
indicated, discussions of comprehensive deposit insurance 
reform.
    In addition, it will give us an opportunity to probe some 
of the comments that I hear back in Rhode Island that 
businesses find it harder to get credit, certainly small 
businesses, not in the context of the credit crunch of about a 
decade ago, but just simply the difficulty of working with 
these larger institutions. This is an important opportunity to 
examine the financial services industry and I thank you for 
your foresight in calling the hearing, Mr. Chairman.
    Chairman Sarbanes. Thank you very much, Senator Reed.
    Senator Allard.

                COMMENTS OF SENATOR WAYNE ALLARD

    Senator Allard. Mr. Chairman, I just want you to know that 
I think it is good that you are moving forward here with an 
oversight hearing on the condition of the banking system. As 
the previous Chairman and now Ranking Member of the Housing 
Subcommittee, I personally focused on safety and soundness of 
housing programs such as FHA and the government-sponsored 
enterprises. Obviously, I am enthusiastic to see us focus on 
the safety and soundness of the banking system.
    I am a big believer in oversight. Each Congressional 
committee should take seriously its oversight responsibilities 
for the agencies under its jurisdiction. I look forward to 
hearing from each of the principal regulators of our banking 
systems.
    I would just second the comments of my colleague from 
Texas, Senator Gramm, that we have the greatest banking system 
in the world. And I believe that America is better for it.
    Thank you.
    Chairman Sarbanes. Thank you, Senator Allard.
    Senator Corzine.

               COMMENTS OF SENATOR JON S. CORZINE

    Senator Corzine. Thank you, Mr. Chairman, and Ranking 
Member. I congratulate you both for very positive leadership in 
the whole process of dealing with the regulatory oversight 
function and the advancements that I think have occurred in the 
financial system in the last decade, including the recent 
legislation modernizing financial markets.
    I also want to congratulate and welcome the regulators. I 
think that they have done an outstanding job in actually 
treading through waters that, in retrospect, look a lot calmer 
than they probably felt when you went through them. There were 
a number of shocks and dislocations that were more difficult to 
manage than I think may appear the case today.
    Finally, I would just like to say that I think the balance 
that is struck between the private sector's participation, 
obvious participation, and the effectiveness of our regulatory 
structures has been a fundamental underpinning of that great 
sound banking system that is an important part of our economy 
and the growth of our economy through the years. This is one of 
those places where I think we have the balance just about 
right.
    Chairman Sarbanes. Senator Bunning.

                COMMENTS OF SENATOR JIM BUNNING

    Senator Bunning. Thank you, Mr. Chairman. I believe it is a 
very good idea to have the regulators periodically come before 
the Congress. Chairman Greenspan often comes up here and we can 
ask him questions about monetary policy, as well as the banking 
system questions.
    Mr. Chairman, I would like to thank all of our witnesses 
for testifying today and I would like to thank you for holding 
this important hearing. But the other regulatory agencies do 
not get a chance to visit us as often. I believe it is 
important that we communicate. Sometimes we feel that 
regulations written do not accurately reflect our legislative 
efforts. I hope we can do a better job of communicating our 
intentions as you continue to advise us.
    I do not think there is any debate that the safety and 
soundness of our banking system is of paramount importance. The 
system is working well, but we must remain vigilant to ensure 
its continued success. That success is critical, not only to 
ensure our Nation's financial stability, but also given the 
importance that our system holds in the financial world 
markets, it is even that more critical.
    I thank you all for coming here today and I look forward to 
your testimony.
    Thank you, Mr. Chairman.
    Chairman Sarbanes. Thank you, Senator Bunning.
    Senator Dodd.

            STATEMENT OF SENATOR CHRISTOPHER J. DODD

    Senator Dodd. Thank you, Mr. Chairman. And let me thank our 
witnesses once again for appearing before us. We always enjoy 
hearing from them. They offer very valuable and worthwhile 
testimony. I thank you for being here.
    I want to thank you, Mr. Chairman, for hosting today's 
hearing also with my other colleagues. I thank Phil Gramm for 
his leadership during his tenure on the Committee and look 
forward to Chairman Sarbanes' leadership of this Committee. I 
have had the privilege and pleasure of serving with you for 
some 20 years. I am delighted to call you Chairman of this 
Committee now after watching your wonderful work over the 
years.
    I want to thank Donna Tanoue. A couple of years ago, Mr. 
Chairman, Donna came to Hartford, Connecticut and took a whole 
day to get there. It was terrible weather. In terms of just 
reassuring the folks up there, keeping that office functioning, 
as she made tremendous efforts to ensure the safety and 
soundness of our financial institutions. I am very grateful to 
you for the work you did during those years and for your visit 
to Hartford.
    Mr. Chairman, yesterday we had a hearing in this very room, 
and some of my colleagues were here. I know Jon Corzine was and 
I think you were, Mr. Chairman, as well as John Robson, the new 
head of the Export-Import Bank, and Secretary Taylor of the 
Treasury. John Robson made a case that the risk levels, the 
risk profiles, for lending had improved significantly. That was 
the argument, and a number of our colleagues as a result of 
that, the budgetary request from the Administration was reduced 
for the Export-Import Bank by 25 percent, arguing that because 
risk assessments have improved, that we may not need as much 
budgetary authority to support lending. Some of us on the 
Committee found that a bit incongruous in light of some of the 
recent reports out of Asia and Latin America regarding 
instability, to put it mildly.
    Based on the testimony that has been submitted, we will be 
hearing how our Nation's banking system, thrifts and financial 
holding companies, seem to be flourishing. I am not arguing 
with that testimony, and I have such high regard for all four 
of our witnesses, I do not question that at all. However, I 
remain a bit concerned. I hope I can hear this either in the 
testimony or in some of your question and answer period, what 
the potential impact that global financial downturns could have 
on our domestic financial institutions.
    I have listened to all of you at various times talk about 
the global economy and how we no longer can live in an isolated 
world where events in Asia, and Latin America do not impact our 
own financial institutions. In light of yesterday's testimony 
and today's, I hope we might get a chance to touch on that. And 
again, I thank all four of you for your fine work.
    Thank you, Mr. Chairman.
    Chairman Sarbanes. Well, thank you very much.
    We will now turn to the panel. Let me just say that you 
have all submitted to the Committee some very thoughtful 
statements and we are deeply appreciative of that. I think if 
we could hold it to about 10 minutes each in your presentation. 
I know a lot of work has gone in and we want to try to hear you 
out. On the other hand, we have limited time and Members want 
to ask their questions. If you can keep it under 10 minutes, 
the more the better, but I leave that to you. And then we will 
go to a question period.
    Now, Ms. Seidman, I know you had a previous engagement and 
have to leave, I think, at about noon, and we understand that 
when the time comes. Chairman Greenspan, why don't we start 
with you and then we will move straight across the panel to Mr. 
Hawke, Chairman Tanoue, and Ms. Seidman.

                  STATEMENT OF ALAN GREENSPAN

              CHAIRMAN, BOARD OF GOVERNORS OF THE

                     FEDERAL RESERVE SYSTEM

    Chairman Greenspan. Thank you, Mr. Chairman.
    It is the first time I have appeared before you as Chairman 
in a long, long time.
    Senator Bunning. Mr. Greenspan, can you pull the mike up so 
that we can all hear you?
    Chairman Greenspan. Is that better? Good.
    Mr. Chairman and Members of the Committee, I am pleased to 
be here this morning to discuss the condition of the U.S. 
banking system. In my presentation today, I would like to raise 
just a few issues. I have attached an appendix in which the 
Federal Reserve Board staff provides far more detail relevant 
to the purpose of these hearings.
    There are, I believe, two salient points to be made about 
the current state of the banking system. First, many of the 
traditional quantitative and qualitative indicators suggest 
that bank asset quality is deteriorating and that supervisors 
therefore need to be more sensitive to problems at individual 
banks, both currently and in the months ahead. Some of the 
credits that were made in earlier periods of optimism--
especially syndicated loans--are now under pressure and 
examination. The softening economy and/or special circumstances 
have particularly affected borrowers in the retail, 
manufacturing, health care, and telecommunications industries. 
California utilities, as you know, have also been under 
particular pressure. All of these, and no doubt other problem 
areas that are not now foreseeable, require that both bank 
management and supervisors remain particularly alert to 
developments.
    Second, we are fortunate that our banking system entered 
this period of weak economic performance in a strong position. 
After rebuilding capital and liquidity in the early 1990's, 
followed by several years of post-World War II record profits 
and very strong loan growth, our banks now have prudent capital 
and reserve positions. In addition, asset quality was quite 
good by historical standards before the deterioration began. 
Moreover, in the last decade, as I will discuss more fully in a 
moment, banks have improved their risk-management and control 
systems, which we believe may have both strengthened the 
resultant asset quality and shortened banks' response time to 
changing economic events. This potential for an improved 
reaction to cyclical weakness, and better risk-management, is 
being tested by the events of recent quarters and may well be 
tested further in coming quarters.
    We can generalize from these recent events to understand a 
bit better some relevant patterns in banking, patterns that 
appear to be changing for the better. The recent weakening in 
loan quality bears some characteristics typical of traditional 
relationships of loans to the business cycle--the 
procyclicality of bank lending practices. The rapid increase in 
loans, though typical of a normal expansion of the economy, was 
unusual in that it was associated with more than a decade of 
uninterrupted economic growth.
    As our economy expanded, business and household financing 
needs increased and projections of future outcomes turned 
increasingly optimistic. In such a context, the loan officers 
whose experience counsels that the vast majority of bad loans 
are made in the latter stages of a business expansion, have had 
the choice of: One, restraining lending, and presumably losing 
market share; or two, hoping for repayment of new loans before 
conditions turn adverse. Given the limited ability to foresee 
turning points, the competitive pressures led, as has usually 
been the case, to a deterioration of underlying loan quality as 
the peak in the economy approached.
    Supervisors have had comparable problems. In a rising 
economy buffeted by competitive banking markets, it is 
difficult to evaluate the embedded risks in new loans or to be 
sure that adequate 
capital is being held. Even if correctly diagnosed, making that 
supervisory case to bank management can be difficult because, 
regrettably, incentives for loan officers and managers 
traditionally have rewarded loan growth, market share, and the 
profits that derive from booking interest income with, in 
retrospect, inadequate provisions for possible default. 
Moreover, credit-risk specialists at banks historically have 
had difficulty making their case about risk because of their 
inability to measure and quantify it. At the same time, with 
debt service current and market risk premiums cyclically low, 
coupled with the same inability to quantify and measure risk, 
supervisory criticisms of standards traditionally have been 
difficult to justify.
    When the economy begins to slow and the quality of some 
booked loans deteriorates, as in the current cycle, loan 
standards belatedly tighten. New loan applications that earlier 
would have been judged creditworthy, especially since the 
applications are now being based on a more cautious economic 
outlook, are nonetheless rejected, when in retrospect it will 
doubtless be those loans that would have been the most 
profitable to the bank.
    Such policies are demonstrably not in the best interests of 
banks' shareholders or the economy. They lead to an unnecessary 
degree of cyclical volatility in earnings and, as such, to a 
reduced long-term capitalized value of the bank. More 
importantly, such policies contribute to increased economic 
instability.
    The last few years have had some of the traditional 
characteristics I have just described: the substantial easing 
of terms as the economy improved, the rapid expansion of the 
loan book, the deterioration of loan quality as the economy 
slowed, and the cumulative tightening of loan standards.
    But this interval has had some interesting characteristics 
not observed in earlier expansions. First, in the mid-1990's, 
examiners began to focus on banks' risk-management systems and 
processes; at the same time, supervisors' observations about 
softening loan standards came both unusually early in the 
expansion and were taken more seriously than had often been the 
case. The turmoil in financial markets in 1998, associated with 
both the East Asian crisis and the Russian default, also 
focused bankers' attention on loan quality during the continued 
expansion in this country. And there was a further induced 
tightening of standards last year in response to early 
indications of deteriorating loan quality, months before 
aggregate growth slowed.
    All of this might have been the result of idiosyncratic 
events from which generalizations should not be made. Perhaps. 
But at the same time another, more profound development of 
critical importance had begun: the creation at the larger, more 
sophisticated banks of an operational loan process with a more 
or less formal procedure for recognizing, pricing, and managing 
risk. In these emerging systems, loans are classified by risk, 
internal profit centers are charged for equity allocations by 
risk category, and risk adjustments are explicitly made.
    In short, the formal measurement and quantification of risk 
has begun to occur and to be integrated into the loan-making 
process. This is a sea change--or at least the beginning of 
one. Formal risk-management systems are designed to reduce the 
potential for the unintended acceptance of risk and hence 
should reduce the procyclical behavior that has characterized 
banking history. But, again, the process has just begun.
    The Federal banking agencies are trying to generalize and 
institutionalize this process in the current efforts to reform 
the Basel Capital Accord. When operational, near the middle of 
this decade, the revised accord, Basel II, promises to promote 
not only better risk-management over a wider group of banks but 
also less-intrusive supervision once the risk-management system 
is validated. It also promises less variability in loan 
policies over the cycle because of both bank and supervisory 
focus on formal techniques for managing risk.
    In recent years, we have incorporated innovative ideas and 
accommodated significant change in banking and supervision. 
Institutions have more ways than ever to compete in providing 
financial services. Financial innovation has improved the 
measurement and the management of risk and holds substantial 
promise for much greater gains ahead.
    Building on bank practice, we are in the process of 
improving both lending and supervisory policies that we trust 
will foster better risk-management; but these policies could 
also reduce the procyclical pattern of easing and tightening of 
bank lending and accordingly increase bank shareholder values 
and economic stability. It is not an easy road, Mr. Chairman, 
but it seems that we are well along it.
    Thank you.
    Chairman Sarbanes. Very good. Thank you very much, Mr. 
Chairman. You are right on the money on the time, too. We 
appreciate that very much.
    [Laughter.]
    Mr. Hawke, we would be happy to hear from you.

                STATEMENT OF JOHN D. HAWKE, JR.

                  COMPTROLLER OF THE CURRENCY

                U.S. DEPARTMENT OF THE TREASURY

    Mr. Hawke. Thank you, Mr. Chairman, Senator Gramm, Members 
of the Committee. I appreciate this opportunity to discuss the 
condition of the banking system and welcome this hearing by the 
Committee.
    If one were to take a snapshot of our banks today, it would 
show a system that evidences great strength. Capital and 
earnings are at very high levels by historical measure. Yet, if 
one were to look at a moving picture of the system spanning the 
past few years, it would disclose trends that cause concern. 
Let me elaborate.
    The last decade has been a period of economic prosperity 
and strong growth in the banking sector. Commercial bank credit 
grew by over 5 percent per year during the 1990's. During this 
period of prosperity, most banks strengthened their financial 
positions and improved their risk-management practices.
    As a result, the national banking system is in a much 
better position to bear the stresses of any economic slowdown. 
National banks are reporting strong earnings with a return on 
equity (ROE) for the first quarter of this year of 15.2 
percent--a level considerably higher than the ROE of 11.5 
percent prior to the last economic slowdown in 1990-1991. 
Fifty-five percent of banks reported earnings gains from a year 
ago. Asset quality for the national banking system is better. 
The ratio of noncurrent loans--that is, loans that are 90-plus 
days past due and in a nonaccrual status--to total loans is 1.3 
percent, compared to 3.3 percent in the first quarter of 1990, 
the year marking the start of the last slowdown. And capital 
levels are at historical highs. As of the first quarter of 
2001, the ratio of equity capital to assets was 8.9 percent, 
compared to 6.0 percent in the first quarter of 1990.
    Greater diversification of income sources improved the 
quality of bank earnings during the 1990's. This 
diversification trend should improve the capacity of banks to 
weather difficult economic times and better manage the risks 
embedded in their operations. The trend away from reliance on 
traditional interest income is in part an active effort by 
banks to better manage risk. As a supervisor, we strongly 
support the efforts of national banks to diversify their 
revenue streams through financially related activities.
    Banks have also made gains during these years in 
diversifying risks. Loan securitization has become a 
significant funding tool. Banks have broadened the geographic 
scope of their operations and increased the range of financial 
services they offer, providing them with a greater capacity to 
weather adverse economic developments. Advances in information 
technology along with more sophisticated risk measurement tools 
now provide bank managers with advanced risk-management tools 
that were unavailable a decade ago.
    There are, however, trends that concern us, and banks 
cannot afford to be complacent about the risks that will 
continue to surface in the current economic environment, 
particularly in the areas of credit and liquidity.
    While the level of loan losses is still relatively low, 
since 1997 the OCC has been concerned about a lowering of 
underwriting standards at many banks. This relaxation of 
standards stems from the competitive pressure to maintain 
earnings in the face of greater competition for high-quality 
credits, particularly from nonbank lenders. In some cases, 
banks' credit risk-management practices did not keep pace with 
changes in standards. We now are beginning to see the 
consequences of those market and operational strategies in a 
rising number of problem loans.
    One area where this is most noticeable is in our annual 
review of Shared National Credits. In 1999 and 2000, adversely 
rated Shared National Credits increased 53 percent and 44 
percent, respectively. In addition, the severity of 
classifications increased in both years. While this year's 
Shared National Credit review is not yet complete, we expect 
problem credits will rise further, reflecting the effects of 
prior lending excesses, a slowing economy, and improved risk 
recognition by bankers themselves.
    And this emerging deterioration of credit quality is not 
just an issue for large banks. As corporate earnings have 
weakened, the spill-over effects on credit portfolios are 
beginning to show up in the smaller institutions.
    Funding risk at banks is also increasing as households and 
small businesses reduce their holdings of commercial bank 
deposits. Banks have traditionally relied on consumers and 
small businesses in their communities as a major source of 
funding. With the rapid run-up in the stock market in the 
1990's, however, and the widespread popularity of money market 
mutual funds, households and small businesses have increasingly 
shifted their savings and transaction accounts into pension 
funds, equities, and mutual funds.
    Our job as bank supervisors is to maintain a sound banking 
system by encouraging banks to address problems early so that 
they can better weather economic downturns and are in a 
position to contribute effectively to economic recovery.
    By acting early, in a measured and calibrated way, bank 
supervisors can moderate the severity of problems in the 
banking system that will inevitably arise when the economy 
weakens. By responding when we first detect weak banking 
practices, supervisors can avoid the need to take more 
stringent actions during times of economic weakness. We make 
our greatest contribution to a sound economy by working to 
preserve the ability of our banks to make creditworthy loans 
when the demand exists.
    Since 1997 the OCC has implemented a series of increasingly 
firm regulatory responses to rising credit risks and weak 
lending and risk-management practices. These efforts, which are 
highlighted in my prepared statement, have focused on 
maintaining an open and candid dialog with the banking industry 
and our examiners about rising risk in the system and the need 
for improved risk-management by bankers.
    National banks have responded positively to these 
initiatives. Bankers are adjusting both their risk selection 
and underwriting practices. Credit spreads are wider, recent 
credit transactions are better underwritten than they were as 
little as 12 months ago, and speculative grade and highly 
leveraged financing activity has slowed in both the bank and 
public credit markets. The OCC has also taken a number of 
steps, particularly examiner training and banker education, to 
address our concerns about increasing liquidity and funding 
risk.
    We recognize that we need to ensure a balanced approach as 
economic conditions weaken. We have implemented, and will 
continue to follow, a careful but firm approach to addressing 
weak practices and increasing risks. In this regard, we are 
constantly mindful that the alternative approach of silent 
forbearance can allow problems to fester and deepen to the 
point where sound remedial action is no longer possible--a 
lesson that all bank supervisors learned painfully in the late 
1980's and early 1990's.
    If we learned anything from past economic crises both in 
the United States and overseas, we know that a sound banking 
system is essential to continued economic growth. I can assure 
you that the OCC will remain vigilant in our efforts to 
continually improve the risk-management of national banks and 
thereby contribute to a viable, healthy industry to support our 
economy.
    Thank you, Mr. Chairman.
    Chairman Sarbanes. Well, thank you very much, Mr. Hawke.
    Ms. Tanoue, let me say that I know that you have announced 
you will be stepping down I think on July 11 or 12. I want to 
join with the comments that were made by Senator Dodd and other 
expressions that you have received in thanking you very much 
for your distinguished service and your leadership at the FDIC 
over these now somewhat more than 3 years. We really appreciate 
the contributions that you have made. You have done real public 
service and we are all very grateful to you for it. We would be 
happy to hear your statement.

                STATEMENT OF DONNA TANOUE, CHAIR

             FEDERAL DEPOSIT INSURANCE CORPORATION

    Ms. Tanoue. Thank you very much.
    Mr. Chairman, and Members of the Committee, thank you for 
the opportunity to testify on behalf of the Federal Deposit 
Insurance Corporation (FDIC) regarding the condition of the 
bank and thrift industries and the deposit insurance funds.
    I am pleased to join with my colleagues here today to 
report that the banking and thrift industries continue to 
exhibit strong financial results. The two insurance funds 
reflect the favorable condition of the industry as well.
    The most important message that I wish to leave with you 
today is that there are flaws in our deposit insurance system 
and they warrant your attention. The best time for constructive 
debate on changes to the deposit insurance system is now, 
during a period of financial health for the industry, rather 
than in the charged atmosphere of a crisis. Even in these good 
economic times, the Bank Insurance Fund has not been keeping 
pace with insured deposits. Consider this--the Bank Insurance 
Fund, or BIF, reserve ratio stood at 1.39 percent at year-end 
1997. A combination of factors pushed it down to 1.35 percent 
by year-end 2000. And very rapid deposit growth has pushed the 
BIF reserve ratio even further down another three basis points, 
to 1.32 percent at the end of the first quarter of this year. 
The Savings Association Insurance Fund, or SAIF, has been more 
stable and stood at 1.43 percent of insured deposits at the end 
of the first quarter, the same as year-end 2000.
    But we shouldn't assume that the current good times for the 
industry will last forever. We are already seeing signs of 
stress that indicate that continued strong industry performance 
will be much more difficult to achieve in the future. The signs 
of stress include shrinking net interest margins, increasing 
numbers of problem loans, and concentrations of higher risk 
loans as a percentage of capital. In addition, as highlighted 
in our testimony, the FDIC is keeping a close watch on certain 
subprime lending activities, developments in the agricultural 
sector, and the efforts of banks to address their funding 
needs. While all of these signs of stress are real, I do not 
want to overstate them. Depository institutions remain in a 
position of strength. And we should take advantage of this 
strength to reform the deposit insurance system now, instead of 
waiting until the industry weakens and the flaws in the system 
become more evident.
    Our deposit insurance system has 2 primary flaws. First, 92 
percent of the insured institutions in our country pay no 
premium for coverage--rendering the risk-based premium system 
ineffective, reducing the incentive for banks to avoid risks, 
providing incentives for rapid growth, and forcing safer 
institutions to subsidize riskier ones. Second, our current 
system could also have a harmful economic side effect, a 
procyclical bias, a tendency to make an economic downturn 
longer and deeper than it might otherwise be.
    During a severe downturn, the current statutory framework 
would require that the FDIC charge banks high premiums, perhaps 
as high as 23 basis points, limiting the availability of credit 
to communities when they need it most and impeding economic 
recovery.
    The FDIC essentially has put forward 5 recommendations, and 
I would like to go over them very briefly.
    Recommendation one--the FDIC should be given the authority 
to charge all institutions premiums on the basis of risk, 
independent of the level of the deposit insurance fund. The 
FDIC, like other insurers, should price its product to reflect 
its risk of loss.
    Recommendation two--the laws should be changed to eliminate 
sharp premium swings. If the fund falls below a target level, 
the law should allow premiums to increase gradually. Charging 
premiums more evenly over time, allowing the insurance fund to 
absorb some losses temporarily, and increasing premiums more 
gradually than is required at present would soften the blow of 
an economic downturn.
    Recommendation three--the FDIC should be given the 
authority to rebate portions of deposit insurance premiums 
based on past contributions to the fund, when the deposit 
insurance fund is above a specified target level. Tying rebates 
to the current assessment base would increase moral hazard. 
Fairness dictates that rebates should be based on past 
contributions to the fund. Allowing the FDIC to pay rebates 
would create a self-correcting mechanism to control the growth 
of the fund.
    Recommendation four--the Bank Insurance Fund and the 
Savings Association Insurance Fund should be merged. The FDIC 
has recommended this for years, in large part because the 
resultant fund would be stronger and more diversified.
    Recommendation five--deposit insurance coverage should be 
indexed for inflation so that deposits do not see the real 
value of their coverage erode over time. While the Congress 
should decide on the initial coverage level, indexing would 
provide a more systematic method of maintaining the real value 
of deposit insurance coverage.
    I would like to thank you, Mr. Chairman, and all the 
Members of the Committee once again for the opportunity to 
testify today and to present the FDIC's reform proposals, and 
also for your very kind and supportive words. I hope that this 
Committee and the Congress, working with my successor, will be 
able to address these issues and bring about the needed 
reforms.
    In closing, I also would like to thank my colleagues at the 
FDIC who produced the reform recommendations and so work so 
incredibly hard to ensure a safe and sound financial system for 
the American people. It has been a pleasure and a privilege to 
work with all of you and with them.
    Thank you.
    Chairman Sarbanes. Thank you very much.
    I might just note that the hearing on Donald Powell, who 
has been nominated by President Bush to become the Chairman of 
the FDIC, will be held here next Tuesday morning at 10 a.m. 
Once he has a chance to settle into his position and is part of 
the hearing process that Senator Johnson mentioned, I assume we 
will then have him back before us again to discuss in 
substance--we will get as much out of him as we can next 
Tuesday.
    [Laughter.]
    He is the new boy on the block, and I am sure we will have 
to give him a little time to settle in and then bring him back.
    Ms. Seidman.

              STATEMENT OF ELLEN SEIDMAN, DIRECTOR

                  OFFICE OF THRIFT SUPERVISION

                U.S. DEPARTMENT OF THE TREASURY

    Ms. Seidman. Thank you.
    Chairman Sarbanes and Members of the Committee, it is a 
pleasure to be with you today to bring you up-to-date on the 
state of the OTS-supervised thrift industry. It is a particular 
pleasure because the current state of the industry is in such 
stark contrast to its condition not very long ago.
    As of the end of March 2001, OTS supervised 1,059 
institutions, with $953 billion in assets. That is about 10.7 
percent of all depository institutions and 12.5 percent of 
assets. And yet, in 2000, and again in 2001, thrifts originated 
over 20 percent of all one- to four-family mortgages made in 
the United States, including mortgages made by nondepository 
institutions. Over 48 percent of aggregate thrift assets are in 
whole one- to four-family loans. Ninety percent of all thrift 
institutions hold under a billion dollars in assets and 43 
percent are smaller than $100 million. These are your community 
banks.
    Almost 40 percent of the institutions are still in mutual 
form, although they hold only about 7 percent of industry 
assets. These institutions have a particularly strong community 
orientation, which I know many of you are personally familiar 
with.
    During 2000, the industry earned $8 billion, a pace that 
continued in the first quarter of this year with earnings of 
$2.16 billion. Return on assets stood at 91 basis points for 
2000, 92 basis points for the first quarter of this year, and 
has been over 90 basis points for the last 3 years, a feat not 
accomplished by this industry since the late 1950's.
    Increasingly, earnings are coming from sources other than 
net interest margin. Whereas, in 1990, noninterest income as a 
percent of gross revenue was 5.1 percent, it was 12.4 percent 
at the end of 2000. Thrifts hold an increasing number of 
noninterest-bearing deposit accounts. That is, checking and 
other transaction accounts that provide both a relatively 
inexpensive funding source and a source of fees, and manage 
over $420 billion in trust assets compared to just under $14 
billion just 5 years ago.
    Equity capital stands at 8.1 percent of assets and 98 
percent of the institutions are well capitalized. Asset 
quality, as would be expected in an industry heavily 
concentrated in one- to four-family mortgages, is 
extraordinarily good, with troubled assets at 0.6 percent of 
assets in the first quarter and charge-offs at 0.19 percent.
    While there has been some increase in noncurrent loans, 
primarily in the 10 percent of thrift assets that consist of 
commercial, construction, and nonresidential mortgage loans, 
recently we have seen a decline in loans 30 to 89 days past 
due.
    Moreover, good asset quality has been accompanied by a 
marked reduction in interest rate risk, which is the bane of 
the traditional thrift institution. As of the end of the first 
quarter, 73 percent of all thrifts were classified as low risk 
for interest rate sensitivity, 18 percent medium risk, and only 
9 percent as high risk.
    Since 1989, OTS has had in place a stress test based 
supervisory strategy for evaluating the interest rate risk of 
all institutions we regulate. As a result, both we and the 
institutions we supervise are able to quickly assess and deal 
with any increase in interest rate risk sensitivity, whether 
resulting from changing interest rates or from funding from 
noncore deposit sources, including Federal Home Loan Bank 
advances with embedded options.
    The number of problem institutions, those with CAMELS 
ratings of 4 or 5, remains low at 14, with only 0.5 percent of 
industry assets. The number of institutions with CAMELS ratings 
of 3 showing some weakness, particularly weaknesses that have 
not been corrected as a result of prior exams, increased during 
1999 and 2000, as was consistent across both the thrift and the 
banking industry, but has recently started to decline. And 91 
percent of the 90 3-rate institutions are well capitalized, 
which means they have a capital cushion that will enable them 
to work out their difficulties in an orderly manner.
    Supervision at OTS is the responsibility of our 5 regional 
offices. All of our examiners--safety and soundness, 
compliance, information technology, and trust--work out of the 
regions and are supervised by experienced regional directors. 
However, through two unique supervisory tools, OTS maintains 
consistency across the country and with agency policy, enhances 
interagency communications, and stays on top of developing 
events at high-risk or high-profile institutions.
    Ten times each year, the most senior D.C. supervisory and 
legal staff, including me, get together with the 5 Regional 
Directors. We discuss current issues and problems, develop 
policies that are effective because they are developed by the 
people who will actually implement them, and resolve 
differences.
    Our other unique supervisory tool is the regular use of 
videoconferencing between Washington and the regional offices 
to discuss high-risk or high-profile institutions. We do this 3 
times a year for each region, a total of 15, 2 to 5 hour 
sessions, with each regional director and his senior staff and 
senior D.C. supervisory and legal staff, and cover well over a 
100 institutions annually. We use these sessions primarily to 
make certain that supervisory strategies are effective and are 
being stepped up where problems linger.
    We have also spent a good deal of time over the past 2 
years working with the institutions we regulate to help them 
focus on long-term profitability. This is particularly 
important in the increasingly competitive financial services 
environment, where there is a tremendous temptation to reach 
for yield without proper planning, systems, monitoring, 
reserving or capitalization. This can lead not only to 
financial difficulties, but also to violations of laws designed 
to protect consumers.
    During 1999 and 2000, we held 5 directors' forums, one in 
each region, in which we reached a total of 1,275 thrift 
directors. In these forums, we discussed the responsibilities 
of a director, including the responsibility for the 
institution's long-term strategic direction. This April, 450 
thrift directors and CEO's joined about 50 OTS senior 
supervisory staff for a conference focused entirely on long-
term profitability, in a world that is not only changing at a 
rapid pace, as evidenced by the 2000 census, but that has also 
gotten far more difficult for community banks.
    The coming years will continue the challenges for both 
thrifts and OTS. As we discuss in more detail in the written 
testimony, issues such as the effective implementation of 
functional regulation, deposit insurance reform, and better 
aligning the thrift charter with the modern-day realities of 
thrifts' role as strong retail lenders and providers of retail 
services, will merit our attention, and yours, over the next 
period.
    In summary, I am very pleased to report that both OTS and 
the institutions it supervises are strong and prepared to meet 
the challenges ahead. I will be happy to answer your questions.
    Thank you.
    Chairman Sarbanes. Thank you very much.
    We have been joined by Senator Bayh since we had the 
opening statements. Before we go to questions, Evan, did you 
have any comments?

                 COMMENTS OF SENATOR EVAN BAYH

    Senator Bayh. Thank you, Mr. Chairman. I will wait my turn. 
But I am grateful to our distinguished guests for appearing 
before us today and I appreciated their comments.
    Chairman Sarbanes. I am struck by the improvement that I 
think has taken place within the regulatory agencies in terms 
of putting oversight systems into place as you interact with 
the private sector, and also by the developments that are 
taking place in the private sector, to which Chairman Greenspan 
and others alluded. I just want to ask some very basic 
questions of the agencies.
    You cannot function well if you do not have competent, 
expert staff. So, I want to address the staffing problem of 
your agencies. I want to make a few observations with questions 
and let you respond as you see proper in terms of your 
personnel.
    First, there have been a number of stories and estimates 
that a large percentage of employees at key Federal agencies 
are going to retire soon. They are approaching eligibility for 
retirement, leaving the agencies with significant operational 
problems, as well as a loss of institutional knowledge and 
human capital. Do you know what percentage of your agency 
employees will be eligible to retire within the next 5 years? 
In your estimates, what percentage are likely to actually 
retire? And what, if anything, is being done to address this 
potential problem?
    Second, a recent paper published in The American Economic 
Review said that the number of newly minted Ph.D's in economics 
who are American citizens might fall below 300 by the year 
2005, in stark contrast to about 600 in the late 1980's and 
early 1990's. Senator Gramm's degree is assuming more and more 
of a scarcity value here.
    Senator Gramm. The good students are now foreign-born.
    [Laughter.]
    When Alan and I got out, the quality started down.
    [Laughter.]
    Chairman Sarbanes. What steps are your agencies taking to 
assure their ability to recruit and retain economists who are 
qualified to understand the complex risk-management associated 
with modern financial institutions?
    Third, we have received reports that some agencies have had 
persistent problems holding on to experienced examination 
staff. What are the causes of this brain drain and what steps 
are you taking to retain your expert personnel?
    Finally, in recent years, the FDIC, the OCC, and the OTS 
have been reducing their staffing levels, as I understand it. 
How does this impact your agency? Do these reductions make 
sense in the face of increasing industry consolidation, 
resulting in ever larger and more complex financial 
institutions? Do these reductions make sense in the context of 
an economic slowdown with some of the problems that come with 
such a slowdown, to which you have alluded in your testimony? I 
would be interested in hearing from each of you on this 
staffing question. Mr. Chairman, why don't we start with you?
    Chairman Greenspan. I think there are 2 major forces in 
addition to the issue of the longevity question, which I think 
varies by organization.
    One is the major shift, in fact, accelerated shift, toward 
high-tech type of evaluations within the banks of their loan 
portfolios; and second, the need for supervisors and regulators 
to obviously be fully conversant with the technologies that are 
involved and the conceptual issues that have arisen over the 
years in advanced risk-management.
    There are remarkably few people out there who are really 
very well skilled in this area and they are obviously in high 
demand. We are fortunate in that we have a few and, in a 
certain sense, you only need a few, to understand what 
effectively is happening within the banks and what type of 
oversight is necessary with respect to the technologies that we 
confront.
    I do not think we can out-compete, in a financial sense, 
the prices, the wage levels, the compensation, that a number of 
these people will get in the financial community, but we do 
find that there are enough dedicated people who wish to work 
within, for example, the Federal Reserve, and I presume in the 
other agencies, because the work is exceptionally interesting. 
It is an interesting, different type of supervision and 
regulation than we have had in decades past.
    So, I do think there is a problem. I do not, at least from 
the point of view of the Fed, sense that we are in any way 
falling short in our capacity to keep up with the ever-
increasing conceptual needs of supervision and regulation. But 
it is a never-ending task, and I would suspect that we have to 
keep up with it in a way which on occasion we may find 
ourselves falling behind the curve, but for the moment, the 
best way I can tell is I do not get a number of memoranda 
coming through my desk which indicate problem X, problem Y, 
problem Z. And that is usually a fairly good measure because, 
believe me, when we do have problems, my ``in'' box gets filled 
up.
    Chairman Sarbanes. Mr. Hawke.
    Mr. Hawke. Mr. Chairman, let me start by saying that I am 
constantly in awe of the quality and dedication of the people 
at the OCC. We really have an outstanding workforce that is 
tremendously dedicated. I think that is demonstrated by the 
fact that a great many of our senior people are well beyond the 
time when they could retire, and for the reasons that the 
Chairman was just explaining, stay with us and continue to make 
an enormous contribution.
    The average experience of our examiners is 13 years. That 
means we have a substantial number of very experienced 
examiners. On the other side of that coin is that we also have 
a substantial number of examiners who have not lived through 
troubled times in the banking system.
    Many of our examiners were not on board during the time of 
real stress in the system in the late 1980's and early 1990's. 
One of the things that we have been doing recently in the face 
of increasing problems with credit quality is training our 
examiners to understand better how to identify and respond to 
risks of a sort that they have not seen before in the system.
    We have made some reductions in the staff, largely to 
achieve efficiencies in the organization. We are exploring ways 
of using technology to increase the efficiency of our 
operation. We initiated a project that we call ``Supervision In 
The 21st Century.'' We are running a pilot project with a 
number of banks now to see how we can use technology to 
decrease the amount of time that examiners have to spend on the 
road and increase the efficiency of the information flow to our 
examiners. So we are trying to make our operation more 
efficient and increase its effectiveness at the same time.
    In terms of recruiting, which was another part of your 
question, we have increased our recruiting at college campuses. 
We are making a special effort to increase the diversity of the 
pool of candidates from which we draw examiners. That is 
something we consider to be very important.
    Chairman Sabarnes. Thank you.
    Ms. Tanoue.
    Ms. Tanoue. Mr. Chairman, you touched on a real challenge 
that exists at the FDIC. On the one hand, we have been trying 
over a number of years to reduce the workforce commensurate 
with the workload. On the other hand, we recognize that over 
the next 5 years, probably about 20 percent of the workforce 
will be eligible for retirement.
    What we have been trying to do, as we downsize the 
workforce is to cross-train and provide additional development 
opportunities for people, say, that are in the liquidation 
area, that are not currently very busy, to train them in other 
areas that they might be ready to step up to. We have also kept 
an inventory of those people who do retire and their specific 
areas of expertise.
    In terms of economists, we also have stepped up the 
recruiting. We recruit and interview at the American Economic 
Association's annual meetings and actually, this year's meeting 
in New Orleans was extremely successful.
    In terms of the recruitment and retention of examiners, as 
the Comptroller mentioned, we too have increased our recruiting 
efforts and are trying to increase the diversity within our 
workforce. We have not encountered significant problems in 
terms of recruiting examiners.
    In terms of retention, we have a concerted effort to make 
sure that our employees, whose talent and expertise is 
immeasurable, feel valued. I think that sometimes is more 
important than the levels of compensation, particularly in 
public service.
    Chairman Sarbanes. Thank you.
    Ms. Seidman.
    Ms. Seidman. Thank you. I too want to emphasize the public 
service element of the situation. Currently, 30 percent of OTS 
employees are over age 50 and 12 percent are over 55. Those are 
some of our very best employees. Because of the pension system 
we have, they have been eligible for retirement actually for 
quite a while now. And yet, they are staying. And they stay 
because they believe in what we do and because we work very 
hard to make sure that they continue to improve and continue to 
increase their abilities.
    When I first came to OTS, we had not hired in 7 years. 
Needless to say, with a workforce that had gotten older, that 
was not a long-term, stable situation. I immediately put into 
effect an examiner recruitment and training program, which has 
been quite successful over the course of the last several 
years. We have been able to add quite a number of examiners to 
our workforce, many of whom are second-career people.
    We use a combination of classroom training and mentoring, 
so that we can take advantage of the skills, the knowledge and 
also, the experienced bank examiners' ``sense of smell.'' Our 
more experienced examiners tell me, and I believe them, that 
they can walk into an institution and sense something is wrong 
pretty quickly. We are trying to impart that to the younger 
examiners. We have a professional development program that is 
available to all of our employees and that is extremely 
successful.
    What we find, frankly, is the reason we lose examiners is 
the travel. It is a very hard life. And so, we have worked very 
hard to increase tele-commuting opportunities and to increase 
other opportunities for examiners to work closer to home or in 
their home, while simultaneously never losing sight of the fact 
that if you are not in an institution when you examine it, you 
are going to miss stuff. There has to be a balance there.
    On the staffing reduction, yes, we have recently had a 
staffing reduction. It was done entirely in Washington. We have 
worked very hard to make certain that our staff in the field, 
from which all our exams are done, as I pointed out, has stayed 
strong and at full force.
    We have done more and more work across regions. We had 
about 800 days of examiner time in 2000 where examiners worked 
out of region. And while that seems to contradict the concerns 
about travel and tele-commuting, it is a real opportunity for 
them to see different places, different ways things are done 
and to learn new things, and they value that also.
    So this is not an easy question. It is one that we work 
enormously hard at and that, frankly, has been one of the 
things that I have worked hardest at since I have been at OTS. 
But it is an area that I think we have a good handle on.
    Chairman Sarbanes.Thank you. I have other questions. I will 
reserve them until the second round.
    Senator Gramm.
    Senator Gramm. Well, Mr. Chairman, let me thank you again 
for the hearing. Let me say that I do believe, and I am 
convinced, that there are a lot of dedicated people who want to 
work for the Government. I can hire people from MIT for $18,500 
because it is cheaper than going to graduate school.
    [Laughter.]
    But the point is they are here to punch their ticket and 
they are going to be gone. I do think it is important to have a 
few people with gray hairs on their head around. We do have a 
pay problem and it begins on the Board of Governors of the 
Federal Reserve, not the Chairman, but members. I can 
personally say that people that I thought should be appointed 
to the Board have refused to be considered, in part, because of 
pay. I think we are very foolish in government when we are 
tight with paying people good salaries. I would rather have 
fewer people that are better paid and more competent, than to 
have big agencies. I just wanted to throw that in.
    I have two questions: one that I would like to ask you, 
Chairman Greenspan, and then one I would like to ask everybody.
    I am concerned about the GE-Honeywell problem and the 
action by the European antitrust division to question the 
merger. Even though being domiciled for an international 
company is not as relevant as it once was, by traditional 
definitions, these are both American companies.
    Maybe I am overreacting to that. As I am sure you are 
aware, Mr. Chairman, in April, the European Union proposed a 
financial conglomerate directive basically concerning financial 
conglomerates operating in Europe. They raised, at least in a 
formal sense maybe for the first time, the question about 
whether to accept the regulatory supervision and decisions of 
the home country regulators or whether to actually go behind 
that in exercising regulatory authority over the conglomerate 
if much of it is in another country, outside Europe.
    Now, I understand that these are problems that we are going 
to have to come to grips with because the plain truth is there 
is no such thing as an American company any more. These are 
world companies. But I would like to get your thoughts about 
this and, particularly, any concerns you have about it.
    Chairman Greenspan. Senator, I think we are dealing in this 
area with some of the very deep cultural values of differing 
countries. The issue of bankruptcy, for example, seems to be a 
technical one. We have, however, very great difficulty unifying 
international bankruptcy codes, largely because the view of 
debtor-creditor relationships is a deep-seated view of 
fundamental relationships in a society. And I can tell you the 
differences that we have run into in that particular regard are 
really quite surprising.
    The same thing exists, as far as I can judge, in the 
antitrust area. In the United States, for example, our 
fundamental premise is the health--I should say, the advance--
of consumer interests and that all focuses on enhancing 
competition, which is fundamentally the underlying rule of all 
American antitrust statutes. We do not, for example, 
particularly try to protect the competitors of individual firms 
who are involved in antitrust suits. Our focus is solely on the 
consumer.
    That is not true in Europe. And it is not true in a lot of 
places, that there is a fundamental view about the nature of 
competition, in some cases, classified as cutthroat and 
therefore undermining the stability of the society and its 
values. Since it is increasingly very difficult to 
differentiate the nationality of individual conglomerates, I 
think somewhere down the line major antitrust jursdiction are 
going to have to reconcile their differences. But I do think 
that the issue you are raising is an important one and one 
which must be resolved if we are going to continue to get the 
benefits of globalization, which, in my judgment, are many.
    Senator Gramm. Well, I would just like to say, and I won't 
ask my second question because I have run out of time, but I am 
especially concerned about the action of the European Union 
because they have adopted a privacy policy that is unworkable, 
and as a result, they want to impose it on everybody else.
    We can question the logic of their environmental policy and 
their regulatory policies. But my concern is that we do not end 
up having bad policies imposed on us as Europeans try to 
protect themselves against competition when they have lost 
their competitive edge based on their policies that they have 
implemented either through their super-national government or 
at the national level. This is something that we are going to 
have to look at very closely.
    I thank you, Mr. Chairman.
    Chairman Sarbanes.Thank you, Senator Gramm.
    Senator Johnson.
    Senator Johnson. Thank you, Mr. Chairman. I appreciate you 
raising the issue about staffing. I wear another hat in the 
Appropriations Committee and this is an issue of concern to me 
as well.
    Chairman Tanoue of the FDIC, on April 5, made 5 
recommendations which she again restated here today. That is, 
the merger of the bank insurance fund and SAIF, indexation of 
insurance coverage, changing the premiums on institutions' 
risk, risk-based premiums, shift from a designated reserve 
ratio of 1.25 to a target level, and a rebate based on historic 
contributions.
    I would like to put the question to Chairman Greenspan and 
Comptroller Hawke and Director Seidman about the impact on the 
banking and thrift industries of implementing the FDIC's 
proposals for risk-based premiums, the merger of BIF and SAIF, 
and the raising of the insurance per-deposit account. And I 
wonder if you could just briefly share some thoughts with me on 
those three points in particular.
    I have an 11:30 a.m. commitment that I cannot avoid and I 
may wind up leaving before all of the answers are made. But I 
want them on the record. And I appreciate the insights that you 
might be able to share with us.
    Chairman Greenspan.
    Chairman Greenspan. Senator, I think that Director Tanoue 
has raised some very thoughtful issues with respect to the 
question of deposit insurance and its impact on the economy. 
These are very important issue which we at the Federal Reserve 
Board have not considered as a board. I think it would be 
better that I address those issues in the context of speaking 
for the Board, which I cannot at the moment, rather than for 
myself. So if you would like an official response from us, I 
would be fairly glad to provide that in writing.
    Chairman Greenspan official response:

    You asked about the impact on banks and thrifts of the 
implementation of three FDIC proposals.
    Risk-based premiums: The FDIC recommends that the current 
statute be amended to permit it to adopt a more flexible risk-
based premium plan, with premiums based on a large number of 
variables that research suggests are related to the fund's 
exposure. We support that proposal.
    A robust risk-based premium system would be technically 
difficult to design. However, the Board believes that the 
potential benefits are worth the effort. A tighter link between 
insurance premiums and risk exposure to the fund would, by 
affecting the ex ante behavior of banks and thrifts, reduce 
moral hazard and the distortions in resource allocation that 
accompany deposit insurance. Risk-based premiums would be 
another factor increasing the cost of risk taking and simulate 
what the private market would do to the cost of deposits if 
there were no deposit insurance.
    However, to be effective in changing behavior and to 
reflect differences in risk exposure, the range in premiums 
would have to be significant. Capping risk-based premiums, say, 
as the FDIC suggests, at about 30 basis points, in order to 
avoid inducing the failure of weak entities, would sharply 
reduce the benefit of the proposal. The Board believes that 
capping premiums may end up costing the insurance fund more in 
the long run should weak institutions fail anyway, with the 
delay increasing the ultimate cost of resolution. We would thus 
recommend that, if a cap is required, it should be set quite 
high so that risk-based premiums can be as effective as 
possible in deterring excessive risk-taking.
    Merger of BIF and SAIF: We support the FDIC's proposal to 
merge the BIF and SAIF funds and believe that the public and 
both sets of depository institutions would be better off if 
this merger occurred. Because the charters and operations of 
banks and thrifts have become so similar, it makes no sense to 
continue the separate funds. The insurance products provided to 
the two sets of institutions are identical and thus the 
premiums should be, as they are today, identical as well. Under 
current arrangements, the premiums could differ significantly 
if one of the funds fell below the designated reserve ratio of 
1.25 percent of insured deposits and the other fund did not. 
Merging the funds would also diversify their risks and reduce 
administrative expenses.
    Per-deposit account insurance limit: The Board does not 
support the FDIC recommendation to index the current $100,000 
ceiling on insured deposits.
    We can see no evidence that depositors are disadvantaged by 
the current ceiling. Depositors who want more insured deposits 
are adept at opening multiple accounts, which is consistent 
with standard investment advice to diversify asset holdings. 
The trend for some time has been not only for households to 
diversify among deposit issuers, but also to diversify their 
holdings among different types of financial assets as 
attractive new market instruments have developed. There has 
been no break in that trend that seems related to any past 
change in insurance ceilings and it seems doubtful to us that 
the shift from deposits to equities that was so significant in 
the late 1990's would have been affected at all by a higher per 
account ceiling. Indeed, the weakness in equity markets in 
recent months has been marked by an increase in deposit flows 
to banks and thrifts.
    Depositories do not seem to have had any significant 
problems raising funds under the current ceilings. Indeed, the 
smaller banks, which one might have expected to have the 
greatest difficulty, have had the most success. Adjusted for 
bank mergers, in the second half of the 1990's the smaller 
banks have grown more rapidly and--at over a 20 percent annual 
rate of growth--have increased their uninsured deposits at 
almost twice the rate of the largest banks. Clearly, small 
banks have a demonstrated skill and ability to compete for 
uninsured deposits.
    The Board has concluded that, with no evidence of harm to 
the public or to depositories, and with no evidence that 
indexing is needed now to stabilize the banking or financial 
system, there is no reason to expand the moral hazard of the 
safety net by indexing the insured deposit ceiling. There may 
come a time when the Board finds that households and businesses 
with modest resources are finding difficulty in placing their 
funds in safe vehicles and/or that there is reason to be 
concerned that the level of deposit coverage could endanger 
financial stability. Should either of those events occur, the 
Board would call our concerns to the attention of the Congress 
and support adjustments to the ceiling by indexing or other 
methods.

    Senator Johnson. I understand your point of view on that, 
Mr. Chairman, and I would very much appreciate presenting this 
issue to the Board and--
    Chairman Greenspan. I can answer the economic issues, but 
not without getting into the implications of where the Board 
may or may not come out with respect to her thoughtful 
recommendations.
    Senator Johnson. Very good.
    Mr. Hawke.
    Mr. Hawke. Senator, I am quite supportive of the idea of 
risk-based premiums. Of course, I sit on the FDIC Board and 
participate to some extent in the formulation of the FDIC's 
proposals. There are some points of difference that we have 
with the FDIC on some aspects of it, but I would say nothing 
fundamental.
    On the question of deposit insurance coverage limits the 
jury is still out. It is not clear to me whether increasing 
deposit insurance coverage limits is going to have the effect 
that many community banks, in particular, hope it would have, 
which is bringing new deposits into the system. I am concerned 
that it may just result in a shifting of deposits among banks 
as opposed to bringing new deposits into the system. I would 
have less concern about coverage limits in an environment of 
fully risk-related premiums.
    One issue that is of major concern to us is the fee 
disparity between State and national banks, which we think 
should be addressed in the context of deposit insurance reform.
    Right now, national banks pay essentially the full cost of 
their supervision. Yet, State banks pay only about \1/10\ of 
the cost of their supervision. They pay for what the States 
provide, but they pay no share of the cost of their Federal 
supervision. In the case of State nonmember banks, that cost is 
taken out of the deposit insurance fund, between $500 and $600 
million a year, which creates a significant inequity between 
State and national banks. We think this is an issue that needs 
to be addressed in the context of deposit insurance reform.
    Senator Johnson. And Ms. Seidman.
    Ms. Seidman. Yes. Let me just say that I, as a Member of 
the FDIC Board, have also been enormously supportive of the 
efforts of Chairman Tanoue and the staff. It has been a process 
that I think has moved a very, very important issue to the 
front burner and focused us in on some of the major problems.
    I believe that the issues of risk-based pricing and the 
procyclicality of the system are issues we need to deal with 
and we need to deal with them well and we need to deal with 
them reasonably quickly and we need to deal with them in a 
comprehensive fashion.
    I have been in favor of merging the funds for as long as I 
have had an opinion on any of these subjects and my opinion 
certainly has not changed as the SAIF has increased above the 
BIF in its reserve ratio. The merger is the right thing to do. 
These 2 funds at this point insure exactly the same kinds of 
institutions. Two of the 5 largest institutions in the SAIF do 
not have a thrift in their corporate family.
    In terms of raising the insurance limit, I am basically 
where the Comptroller is. I do think the jury is out. I think 
there is a real issue about whether this would just result in 
more money flowing into things other than community banks.
    I think there is an issue about what we really believe 
deposit insurance is about, that is, a policy decision for the 
Congress to make. Finally, I think most importantly, unless we 
have true risk-based pricing, I do not think that issue should 
even be discussed.
    Senator Johnson. Thank you, Mr. Chairman.
    Chairman Sarbanes. Thank you.
    Senator Shelby.
    Senator Shelby. Thank you.
    I want to follow up on the insurance. Would you discuss the 
risk of the merger of the funds versus the upside? What are the 
risks if you merge the funds? What are the risks out there? I 
do not see any.
    Ms. Tanoue. There are none.
    Senator Shelby. There are no risks.
    Ms. Tanoue. No. Simply put, a merger of the funds would 
result in a stronger, more diversified fund.
    Senator Shelby. Ms. Seidman.
    Ms. Seidman. Absolutely. There is no risk to not doing it 
and there are risks to leaving it the way it is.
    Senator Shelby. And the risks to leaving it the way it is.
    Ms. Seidman. There are essentially two risks to leaving it 
the way it is. One is that the funds are indeed less 
diversified than they would be if merged. Bank of America, for 
example, I think has something close to 9 percent of the BIF, 
and a significant portion of the SAIF. Even though it has a 
significant portion of the SAIF, combining the two would drop 
it down. Washington Mutual would come way, way down in terms of 
exposure. So with merger, the fund would have much less 
exposure to the largest institutions.
    The second risk that is out there is, and as Chairman 
Tanoue has testified, that the BIF has been dropping in its 
reserve ratio at the same time the SAIF has been stable. If 
that trend continued, you could end up back where we were in 
1995, although, of course, it would be reversed, and you would 
see a situation where institutions with BIF-insured deposits 
would be paying big premiums and institutions with SAIF-insured 
deposits would not be. That is a very bad situation.
    Senator Shelby. Do you want to add anything?
    Ms. Tanoue. I agree. The greatest threat is the potential 
for premium disparity. And many members on this Committee are 
familiar with that experience.
    Senator Shelby. We have talked about this in this Committee 
for many, many years on other occasions. But most insurance 
that I have ever heard of is based on risk, is not it?
    Ms. Tanoue. Absolutely.
    Senator Shelby. I mean, it is based on the underwriting of 
a risk, except to a certain degree, the FDIC.
    Ms. Tanoue. That is a central recommendation that we put 
forward--to put into place a more effective risk-based pricing 
system for all insured institutions, all of whom present risk 
exposure to the fund.
    Senator Shelby. What is the current strength of the FDIC 
fund? Where do you stand today as far as the value of it? What 
is the size? Roughly.
    Ms. Tanoue. The BIF balance is slightly in excess of $30 
billion.
    Senator Shelby. Thirty billion dollars.
    Ms. Tanoue. And SAIF balance is slightly in excess of $10. 
So something in excess of $40 billion combined.
    Senator Shelby. Do you think that is adequate reserves?
    Ms. Tanoue. Well, the issue of what level the fund should 
be is a perennial one and a very important one. There really is 
no set answer to that question. It always involves a trade-off 
in terms of what level of risk you want to cover, what you feel 
is sufficient to protect taxpayers versus whether you want a 
fund to be growing and growing and growing, or whether you want 
some of those monies to be returned back to communities to be 
put to good use.
    Senator Shelby. You were both talking about upping the 
coverage limit on the Bank Insurance Fund. There are certain 
risks there, are there not? If you run the limits up from 
$100,000 to, say, $300,000, there could be risks to the 
taxpayer regarding that down the road, could there not?
    Ms. Tanoue. Yes Senator, there is a concern about increased 
moral hazard.
    Senator Shelby. Absolutely.
    Ms. Tanoue. And Ellen Seidman just made a very important 
point. That is, we believe very strongly that the issue of a 
coverage increase should not be considered in and of itself. 
The issue of risk-based pricing must be taken into 
consideration first before any kind of discussion of the 
coverage increase is considered.
    Senator Shelby. I agree with you.
    Thank you, Mr. Chairman
    Chairman Sarbanes. Thank you, Senator Shelby.
    Senator Reed.
    Senator Reed. Thank you, Mr. Chairman.
    One of the reasons the financial system is so strong is 
that the economy has been strong in the last several years. But 
there are some potential developments. One is an ominously low 
household savings rate. And the second is with our tax policy 
now, we have lessened the surplus, which in a sense is public 
savings. Without savings, it is hard to form capital.
    We are also beginning to see some deterioration of the 
robust productivity numbers of the last several years. All 
together, your view with respect to how the banking system is 
going to cope with what seems to be an inability for American 
households to save.
    Chairman Greenspan. The problem of savings has been a major 
problem in this country for a very protracted period of time, 
Senator. And as you know, as a consequence of that, we 
effectively are borrowing a significant amount of savings from 
abroad, which is our current account deficit.
    The reason it hasn't shown up as a significant economic 
problem is that we have really an extraordinary degree of 
productivity from our savings in the sense we have managed to 
use the limited amount of savings, in a very effective way, so 
that the type of capital which we are producing has tended to 
be the high productivity-producing capital.
    So in part, because of our financial system and, indeed, 
our banking system in general, we have been able to direct the 
limited savings that we do have into the most effective uses. 
In that regard, one must look at the American banking system as 
a very major player in our ability to improve productivity over 
the years with, as you point out, quite a diminished level of 
domestic savings.
    Part of that is the result of the fact that we have created 
a very flexible system and we are able to allocate resources in 
a most effective manner. Is that going to continue indefinitely 
in the future? For the moment, I would suspect, yes. But in the 
distant future, I think that remains to be seen.
    Senator Reed. I wonder, Mr. Hawke, Ms. Tanoue, Ms. Seidman, 
if you have a comment?
    Mr. Hawke. Senator Reed, one aspect of the problem that you 
have mentioned concerns us and that is the deterioration in the 
core deposit base of banks, particularly community banks. Our 
community banks tell us that loan demand remains strong, but 
their ability to raise traditional core deposits is declining. 
They are increasingly turning to other sources of liquidity, in 
particular, the Federal Home Loan Bank system. That has raised 
some concerns of its own for us. But I think it is important 
that liquidity of community banks be considered and addressed. 
It is an important issue that we hear about everyday.
    Senator Reed. Chairman Tanoue.
    Ms. Tanoue. Our testimony places a great emphasis on that 
point as well. But I would add that there is some evidence that 
liquidity pressures are easing. In the last two quarters, we 
have seen a tremendous in-flow of deposits. It would be very, 
very important to keep an eye on that and to see whether that 
is sort of a blip in terms of against a trend or whether it is 
a new trend.
    Senator Reed. Do you have any sort of indication what is 
causing this influx of deposits, initially?
    Ms. Tanoue. Essentially, it is a return by consumers to 
safer havens for their money.
    Senator Reed. Ms. Seidman.
    Ms. Seidman. Our testimony also discusses the liquidity 
issue and I think it is a real one. We just put out a bulletin 
yesterday on managing liquidity risks. But I want to take a 
little different tact here.
    We have all spent a lot of time over the last several years 
thinking about underserved communities and about the role of 
the banking system with respect to the underserved communities. 
Frankly, for a lot of the small community institutions, that is 
where their future is.
    In many of those communities, savings are in the mattress. 
Money is in the cookie jar. I think it is really important for 
our bankers and, again, particularly community bankers, to be 
reaching out to those communities, not just to make one-off 
loans, but to bring those people fully into the financial 
services mainstream with deposit products and investment 
products, as well as loan products.
    I noticed there was an article in today's New York Times 
about this. It is an issue that we have discussed with any 
number of our institutions. It is obviously not going to make 
the savings rate jump way up. But it could provide some greater 
stability to consumers toward the bottom of the economic 
spectrum.
    Senator Reed. Thank you very much.
    Thank you, Mr. Chairman.
    Chairman Sarbanes. Senator Bunning.
    Senator Bunning. Thank you.
    My gosh, I had very few questions and now I have listened 
to everybody else's and I have lots more. Let me just start out 
with what Senator Gramm talked about in keeping good people. 
The Federal Reserve Board appointees have 14 year terms. Is 
that correct?
    Chairman Greenspan. That is correct, Senator.
    Senator Bunning. That is almost as good as a Federal 
district judge. It just depends on what age you are appointed.
    [Laughter.]
    Those funds that we are paying that 14 year term to are 
substantial. So, I disagree with Senator Gramm. I think we are 
paying our people adequately, like we do pay our Federal 
district judges and our appellate judges.
    I want to ask you the question I always ask you, Chairman 
Greenspan, about inflation. Any new or striking points of 
inflation in the current economy and/or close future economy 
you forsee?
    Chairman Greenspan. It is very difficult to see anything 
short-term, Senator. We do know that as the rate of growth has 
slowed down, unit labor costs have gone up as they invariably 
do in such a period. But we have seen no evidence that those 
costs are being passed through into final prices in any 
material way.
    Similarly, we see a fairly extraordinary increase in energy 
costs. And here again, separating corporations into nonenergy, 
nonfinancial, we have tried to trace the movement of energy 
costs into prices. We find that almost all does not go into 
final goods prices, but is squeezing profit margins, which is 
the same thing as unit labor cost.
    Our best measures of consumer inflation are the personal 
consumption expenditure deflators which the Department of 
Commerce produces. And here, the so-called core inflation 
index, that is, total consumer inflation, less what we perceive 
to be the volatile parts of food and energy, that so-called 
core inflation has been relatively stable and shown no evidence 
of it.
    But having said that, I would suggest to you, as I always 
do say, that we have to be very careful about any evidences of 
emerging inflationary instability because history has told us 
time and time again that the most effectively productive 
economies are those with stable prices. And we certainly hope 
to be able to see sufficiently far in advance to fend off any 
emergence of inflationary forces.
    Senator Bunning. Chairman Tanoue, you think that there 
should be an increase, or at least that was one of your 
recommendations to increase the amount of insured deposit. Did 
I misinterpret that?
    Ms. Tanoue. Actually, the FDIC has never taken a position 
in terms of making a recommendation in terms of increasing the 
coverage level. What we have recommended is that wherever the 
Congress chooses to set that initial base level, we have 
recommended that the level be indexed to inflation to maintain 
the real value.
    Senator Bunning. I know the Chairman did not want to answer 
that because he has personally answered it before. He disagrees 
that we should move from the $100,000 deposit insured savings 
accounts. And I understand it is not a position of the Fed, but 
it is a personal position, that you did not want to get into 
that.
    Chairman Greenspan. I think when the issue is put on the 
table as potential legislation, which in effect that is what is 
involved here, it should be the opinion not of the Chairman but 
the opinion of the Board of Governors.
    Senator Bunning. Okay. The BIF and SAIF funds, and I want 
to follow up on my good friend, Senator Shelby--if there is no 
risk, why in the world aren't we doing it?
    Ms. Tanoue. That is a good question. I think, and many 
people have advocated, that the merger of the funds occur. But 
usually what happens, I think as a practical matter, is that 
other issues are tied with the issue of the fund merger. But, 
really, that is an essential change and it should be done.
    Senator Bunning. But, I mean, are the community bankers, 
are the larger bankers--who is stopping it? Because if it is 
the right thing to do, there has to be some opponents out there 
that are stopping it.
    Ms. Tanoue. Generally, there are many issues relating to 
deposit insurance reform, many of which are very complex. This 
is an issue that is probably best taken up within a 
comprehensive approach to these issues, and this is what we 
have recommended.
    Senator Bunning. Thank you very much.
    Thank you, Mr. Chairman.
    Chairman Sarbanes. Thank you, Senator Bunning.
    Senator Corzine.
    Senator Corzine. Yes. I think the BIF/SAIF combination begs 
a question about whether there are greater efficiencies or 
certainties to regulation that might come from a more broad-
based combination, particularly given the increasing 
concentration of assets that might be in the thrift industry 
and that $950 billion. One could at least ask that question. I 
would love to hear comments on that.
    But the main question I would like to hear is, some view 
about the interconnectedness, the systemic exposures that you 
all have mentioned in testimony, but it hasn't been followed up 
with regard to syndicated loans, particularly I think in light 
of nonfinancial institutions increasingly involved in the 
lending process.
    I think that was what Ranking Member Gramm was talking 
about a little bit with respect to the GE and Honeywell merger. 
But it is a problem that is of concern in New Jersey with one 
of our telecommunications companies and I think with Nortel as 
well.
    I know that derivative risk is interconnected and systemic 
of nature and has a credit element. I am concerned that these 
kinds of things do not show up until you have one problem that 
then cascades. And I am concerned that we are not focused as 
much on this, at least in this discussion today, as I might be 
if one were worried about the deterioration of credit quality 
in a system basis.
    I guess you could take that to some of the global, 
sovereign institutions with what one might be concerned about 
in Argentina or Turkey. I would love for anyone to comment on 
both the general status of this. But how is the regulatory 
structure or do you feel that we are adequately able to track 
those interconnected points better than maybe we were at 
another point in time?
    Chairman Sarbanes. I think that is a very good question and 
it is part of what we were trying to get at with this oversight 
hearing. In other words, to start probing and looking ahead to 
get some sense of things that are happening that may be new in 
terms of appearing on the scene, what their implications are, 
and how the regulatory system deals with it.
    Mr. Hawke. Senator, I mentioned in my testimony the Shared 
National Credit process, which is one of the principal 
mechanisms the bank supervisors have for looking for the kinds 
of credit exposure that you have described. In the Shared 
National Credit process, we look at the syndicated credits of 
over $20 million in size, and we have a very large number of 
those credits this year. We do it jointly with the Federal 
Reserve and the FDIC, so we all participate in looking at the 
same credits. And we are trying very hard to make sure that we 
are approaching them in a uniform way. But in that process, we 
get well educated about where sectoral risks are and how banks 
are handling these large credits. That process for this year 
has not run its course yet, and we are awaiting the outcome of 
this year's analysis.
    Senator Corzine. Do you also look at derivative credit 
exposures in that process or mostly at the--
    Mr. Hawke. Not in the Shared National Credit process as 
such, but we just put out a report this week on derivative 
activities at our banks. The notional amount of derivative 
activity has increased, but that really doesn't reflect what 
the risk is in the area of derivatives. Rather, it reflects the 
level of business activity.
    Derivative activity is focused in a very small number of 
very large banks. We and the Federal Reserve, I am sure, watch 
that very carefully in the banks that we supervise. We have a 
core group of experts who work with those banks. At the present 
time, we do not have any great cause for alarm in that area.
    Senator Corzine. Any of the other panelists like to 
comment?
    Ms. Seidman. I would just like to comment that while the 
items that you have been talking about are very important for 
the larger institutions, I think for the mid-size and smaller 
institutions, the biggest risk that we see is this problem of 
reaching for yield in an ultra-competitive world and moving 
from one line of business for the day to another, never quite 
really doing any of it well. And usually, we are able to get in 
there on time and put a stop to it before people get over-
extended. But every once in a while, it moves very fast and 
then it gets very hard to do.
    Senator Corzine. Could I ask you to comment maybe on the 
first question?
    Ms. Seidman. On the first question? Okay. First of all, in 
the thrift industry, the increasing concentration has in fact 
diversified geographic risk, which is probably the greatest 
risk for mortgage lenders. So, I do not think that it has made 
the industry more risky.
    In terms of consolidation, Gramm-Leach-Bliley was able to 
get through after all those years because in many ways the 
regulatory issue was not tackled. We now have a regulatory 
systems in the financial services industry where the insurance 
commissioners, the securities commissioners, the banking 
regulators, not only us, but also all 50 of them in the States, 
the SEC, are all intimately related.
    We are working very hard, all of us, to make this system 
work. For example, OTS has information-sharing agreements with 
45 of the State insurance commissioners. But it is a difficult 
system.
    My personal opinion is that sometime in the course of the 
next decade, it will be up to Congress to face up to those 
difficulties.
    Senator Corzine. Thank you.
    Chairman Sarbanes. Senator Bayh and then Senator Miller, 
and then Senator Schumer. Let me say that Ellen Seidman is 
going to have to leave shortly. So if either of you have 
questions specifically directed to her, you probably ought to 
take that question now. But if not, Senator Bayh, why do not 
you go ahead.
    Senator Bayh. I hope you will not be offended, Ellen, if 
the answer is no.
    Ms. Seidman. It is quite all right. I know that the 
Chairman is the really big draw here.
    Senator Bayh. Mr. Chairman, I would like to thank you for 
holding this hearing. One of our comparative advantages 
economically as a country is our deep and broad and secure 
financial markets, particularly our banking system. And we 
neglect the stability at our peril. So I think this hearing is 
very appropriate and timely.
    I hope the other panelists won't be offended if I address 
three brief questions to Chairman Greenspan building on 
something that Senator Reed mentioned.
    There was a recent analysis done by Goldman Sachs 
suggesting that because of what they predict to be a decline in 
capital investment, the productivity growth rates may average 
\4/10\ of 1 percent less over the next decade than had been 
previously forecast. It was their analysis that this would 
translate into a $1.1 trillion reduction in the anticipated 
surplus.
    My understanding of the historic patterns of productivity 
growth trends is that we have occasionally seen accelerating 
productivity growth that we experienced over the last several 
years. But that, invariably, it regresses to some sort of mean. 
I am interested in your view on productivity growth going 
forward and, in particular, Mr. Chairman, what this means for 
the projected budget surplus.
    Chairman Greenspan. The current services budget surplus has 
essentially been based on a 2\1/2\ percent productivity 
increase annually. The Goldman Sachs analysis brought it down 
to 2\1/4\ percent, as I recall. They were coming originally 
from 2\3/4\ percent. Those are disputable calculations. I will 
say that there is not--
    Senator Bayh. Would Senator Corzine agree with that?
    [Laughter.]
    Chairman Greenspan. I was purposely directing it at you, 
Senator not your colleague on the right.
    Senator Bayh. I appreciate that, Mr. Chairman. Thank you.
    [Laughter.]
    Chairman Greenspan. Besides, Senator Corzine is no longer 
interested in that.
    Senator Bayh. This is true.
    [Laughter.]
    Chairman Greenspan. I was about to say, however, there are 
very legitimate questions with respect to how one comes at 
these types of forecasts, and it was a fairly sophisticated 
approach and I read it very closely. But you have to remember 
that we economists go by issues rather quickly and sometimes 
when you dig a little deeper, there are some open questions. So 
just to say specifically that, in my judgment, I do not think 
we are down that far. In other words, I would not agree with 
the conclusion.
    The issue of translating the change in productivity growth 
into the surplus is relatively straightforward. But remember, 
we are talking about current services budgets here. These are 
the only adjustment to what is under current law a presumption 
that discretionary expenditures go up with the cost of living, 
a scarcely over-liberal interpretation of what usually happens 
to these data.
    So, I do not see any fundamental, long-term changes. In 
other words, I do think that when a 2\1/2\ percent productivity 
growth estimate came out, a lot of people thought it was overly 
conservative. What one may readily argue at this stage is that 
it is less conservative than it was at the time that it was 
done. But I do not see anything in the data, per se, at this 
particular point which should lead one to make any major 
revisions in the current services surplus. Obviously, as the 
Congress moves forward on taxes and on the expenditure side, 
you shift to actual budget surpluses which are clearly going to 
be less than the current services number.
    Senator Bayh. Well, I am encouraged to hear your comments 
about productivity estimates. My concern had been with the low 
rate of personal savings combined with some of the recent tax 
actions taken by the Federal Government that our margin for 
error, the buffer that we had in this country with the size of 
the surpluses, had been reduced. And if you combine that with 
uncertainty and productivity growth, then perhaps we would then 
have a fiscal problem somewhere down the line. The desire to 
take some of the risk out of the projections through triggers 
and things of that sort. But that is a debate that we have had 
and we have moved on.
    I would like to ask one other question before my time 
expires. The robust growth in the U.S. economy has provided a 
buffer for the rest of the world against such things as 
financial contagion from Third World problems, long-term 
capital problems, things of that nature. I would be interested 
in your view, with the slowing of the U.S. economy, how much is 
the vulnerability of the global economy increased to some of 
these external shocks?
    Chairman Greenspan. Senator, that is a very good question 
which we have been focusing on for quite a while. One of the 
problems that we have is that when you actually take 
correlations of growth relationships--in other words, for 
example, between the United States and Europe--we find a much 
higher synchronization of the growth rates in Europe and the 
United States than our very elaborate macromodels can generate. 
Meaning that we can incorporate the trade accounts, we can 
incorporate the financial flows, and a number of things which 
are quite visible to us. And we put them together, try to get 
evaluations of how they all affect the United States and 
Europe, and then simulate various results from which we can get 
a correlation between the growth rates, essentially what is 
reflected in our models of the individual countries.
    But when we look at what actually happens, the correlation 
is much higher, which is another way of saying, we do not yet 
fully understand all of the elements in the international arena 
which are affecting individual countries. So whatever it is 
that we think is happening, it tends to have a significantly 
larger impact on our trading partners and what is happening 
amongst our trading partners has a greater effect on the United 
States than we can readily understand directly, which leads us 
to be, obviously, quite sensitive to what we see going on 
abroad. And indeed, we have put a great deal of effort in 
trying to understand that in a way which we did not 20 years 
ago when those relationships did not exist at the levels they 
exist today.
    Senator Bayh. Thank you, Mr. Chairman. Thank you to the 
rest of the panel.
    Chairman Sarbanes. Chuck, Chris was here at the outset and 
for quite a while and went away. So, I will recognize him now, 
and then you.
    Senator Dodd. Thank you. Let me thank my colleague from New 
York, too. I will be brief. Secretary Powell is testifying one 
floor below you, so we are going back and forth here and 
juggling and I apologize coming in and out of the room like 
this.
    I would like to turn the attention of all four of you to an 
issue that I gather has not been raised in my absence, one that 
I find very, very troubling and has recently come up in the 
context of the bankruptcy bill debate, certainly in the Senate. 
I do not believe the issue came up in the House, although it 
may have. And that is, according to credit card issuers, of 
course, bankruptcy reform is needed because far too many people 
are defaulting on their credit card debts. As a result of these 
defaults, obviously card issuers pass these costs on to other 
credit card users, thereby raising fees and rates. Credit card 
issuers have been extraordinarily persuasive, I might add, in 
both the House and the Senate when coming to this bankruptcy 
bill in terms of what is included. There has been very little 
discussion, other than some amendments that were raised, about 
the underwriting practices, when it comes to the issuers of 
unsecured debt. And so, I would like to address your attention 
to that issue, if I could.
    I am told that under the present economic conditions in the 
country and the slight downturn, there were reports this 
morning, in fact, the national news media, that as many as 1.5 
million Americans could end up taking the Bankruptcy Act this 
year alone. And about a third of those will be people between 
the ages of their 20's and 30's. In fact, an increase. Five 
years ago, the American Banking Institute indicated that 
personal bankruptcies were filed by only 1 percent of those 
people under the age of 25. In 1998, the latest numbers I have, 
that number is up to 5 percent. I do not know what the latest 
numbers are, but it seems to me they are probably moving up 
from what they were.
    I recently offered some legislation in the context of the 
bankruptcy bill that would say that for people who are under 
the age of 21, that you would have to demonstrate, one, an 
independent means of paying your debts or obligations, two, 
have someone cosign for you, or, third--any one of these three, 
not all three, but any one of these three--or proof that the 
applicant had completed a certified credit counseling course, 
some way of at least raising the level, raising the bar a bit.
    Many of you in the past I know have taken the position that 
loans made without consideration of an individual's ability to 
pay constitutes unsafe and unsound business practices. So, my 
questions are for you, one, are the credit card loans made 
solely on the basis of a student ID and a signature? And that 
is what the case is. I am not exaggerating this. Merely signing 
a card and showing your student ID on a college campus will get 
you a credit card.
    I am told by colleges around the country that you are 
looking at as many as 50 credit card applications arriving at 
freshmen's doors at college. The debt now is going up near 
$3,000, almost $3,000 per child. They are children in many 
cases here. There is little or no responsibility being 
exercised by the credit card companies, in my view. And so I am 
very worried that this matter is going to get further out of 
hand and add to further financial burdens of some of the most 
vulnerable people as they have tremendous costs obviously 
associated with higher education.
    I am not suggesting any caps on fees or fixing interest 
rates and the like. But it seems to me that there is a 
commensurate responsibility, not only of the consumer, but also 
of the credit card issuer when it comes to this ever rising 
consumer debt question.
    I wonder if you might comment on the wisdom that the credit 
card companies are engaging in, whether or not this is unsafe 
or unsound to be issuing credit cards to people merely on a 
student ID identification and a signature, whether or not the 
three criteria that I have mentioned you think raise too high a 
bar for the credit card issuers to me. And I would appreciate 
your responses. Mr. Chairman, can we start with you?
    Chairman Greenspan. Jerry Hawke, I am sure knows more about 
this than I, since he regulates a lot of these people. But that 
gives me a wide open avenue to say irresponsible things, maybe.
    Mr. Hawke. I know more about it because my son is one of 
the recipients of those solicitations, and I happen to know a 
lot about his capacity to pay.
    Chairman Sarbanes. That is the way to be a fast learner on 
that issue, that is for sure.
    [Laughter.]
    Senator Dodd. And we have had some very tragic stories, by 
the way. At campuses that offer, by the way, who receive 
thousands and thousands of dollars for exclusivity contracts on 
college campuses. Every now and then we introduce bills and we 
hear from constituent groups. This recieved relatively minor 
attention. I cannot tell you the number of people I have heard 
from around the country who agree that this is something--from 
parents, primarily.
    Chairman Sarbanes. Go ahead.
    Mr. Hawke. I think practices vary, Senator, among 
companies. I had the occasion just a few weeks ago to visit one 
of our very largest credit card banks. And, unlike some others, 
they underwrite every applicant individually. They have a 
battery of people who make traditional kinds of credit 
underwriting decisions on a case-by-case basis.
    With others, it is much more a commoditized product. It is 
done with credit-scoring on a much more mechanical basis. They 
factor in loss rates and, as you pointed out, that all gets 
included in the pricing.
    There is one point that you made that I think is enormously 
important, particularly in the context of a subject that we 
have not talked about this morning: predatory lending. That is 
the lack of underwriting and the extension of credit without 
any consideration of a borrower's ability to repay. I think 
that that is what lies at the heart of what we would generally 
refer to as predatory lending. It is a situation in which 
lenders--and these are not, for the most part, credit card 
lenders, but other types of lenders, and for the most part, 
nonregulated entities--target the equity that people have built 
up in their homes, for example, and push credit out to them for 
the purpose of trying to recover large fees ultimately from the 
equity in their homes.
    We have been putting great emphasis on the need to follow 
traditional bank underwriting in all kinds of credit-granting, 
that is, to assure that the applicant for credit has the 
capacity to service and pay off the loan from conventional 
resources without looking to the collateral that might be 
pledged as the source of recovery. I feel confident that if we 
can get that principle well established and well implemented, 
it will go a long way to dealing with the subject of predatory 
lending.
    Senator Dodd. Do you think the criteria we placed is an 
undue burden or too high a bar to require a credit counseling 
course for someone that young an age might be required to take? 
Is that too heavy a burden?
    Mr. Hawke. I would be hesitant to express a view on that 
because I am not entirely sure what--
    Senator Dodd. If we cannot get your view, whose view do I 
get? You are the people who are going to be responsible for 
this sort of a thing. If we are going to make the case, who do 
I rely on if I cannot rely on you folks to give me an answer to 
this?
    Mr. Hawke. I think part of the answer to the problem of 
predatory lending and other kinds of lending that involve an 
extension of credit to people who really cannot afford it is 
credit counseling. Financial literacy is an enormously 
important subject and one that is worthy of a lot of attention 
because the lack of financial literacy lies at the heart of 
many abusive practices.
    Senator Dodd. These numbers, going from 30 percent of all 
bankruptcies taken by people in their 20's and 30's, starting 
out in life with bankruptcy?
    Mr. Hawke. I think that is staggering.
    Senator Dodd. And the number is going from 1 to 5 percent. 
Isn't that worrisome, if kids under 25, 5 percent of 
bankruptcies? I find that jump rather alarming, do not you?
    Mr. Hawke. I do, yes.
    Ms. Tanoue. Senator Dodd, I would just add some context in 
terms of credit cards. Personal bankruptcies obviously have a 
direct impact on credit card losses. For the last 2 years, 
personal bankruptcies and credit card losses have been trending 
downward. But for the first quarter of this year, there 
actually is an uptick in personal bankruptcies.
    Senator Dodd. Right.
    Ms. Tanoue. Possibly in anticipation of some of the tighter 
rules that you are talking about. But any weakening in the 
economy might be likely to result in more bankruptcies and 
thus, rising losses in credit card loans.
    I would also like to mention that, in terms of some of the 
predatory practices, I can think of at least one very, very 
serious case that we are dealing with where a credit card 
issuer is engaging in certain types of practices, certain types 
of disclosure practices and sales practices, that are very much 
on the margin.
    And we are looking very hard at what the appropriate 
enforcement measures might be with respect to some of the 
standards that have been set under the FTC Act and with respect 
to regulations currently under the banking regulators' 
jurisdiction.
    Senator Dodd. Ms. Seidman, do you have something to add?
    Ms. Seidman. Well, first of all, I am the mother of a 17 
year old, so this is, as with the Comptroller, a very intimate 
subject right now. I think that the issue that you have raised 
with respect to the standards is interesting and important, and 
I want to comment on the third one, which is the credit 
counseling standard. I think the Comptroller is right not to 
just say, yes, and here is my reason.
    As you know, in connection with homeownership for lower 
income families, many, many of the institutions and 
particularly, Fannie Mae and Freddie Mac, have been requiring 
credit counseling to get one of the low downpayment loans.
    Last year, Freddie Mac did a study that indicated that a 
lot of what is called counseling is completely, totally and 
utterly useless. In contrast, some types of counseling, 
particularly the kind done one-on-one by the nonprofits, really 
do seem to have a real impact.
    So, I am a little bit concerned about that third prong. 
Without some standards for what you mean by credit counseling, 
you are not going to have much of a result.
    Senator Dodd. If I dropped the third one, then--
    Ms. Seidman. No, no. The problem is you have to improve the 
third one, not drop it.
    Senator Dodd. It is a choice. You do not have to do all 
three. You could have it cosigned by someone else or 
demonstrate the ability to pay.
    Ms. Seidman. I hear you.
    Senator Dodd. That sounds like an outrageous request to me, 
that an institution is lending you, in effect, money with a 
credit line of $3,000, $4,000, $5,000, $7,000, and you need 
nothing but your signature and a student ID. Now, come on. This 
is outrageous.
    Ms. Seidman. I understand. I also think it is terribly 
outrageous that the universities are not only allowing this 
situation, but also participating in it. And I think there are 
a lot of places where we have to get after this.
    Senator Dodd. But I do not hear--it is kind of silent. And 
I am looking to you folks to say something. We offer 
amendments, but it always helps to have folks who are out there 
dealing with these institutions to speak out on this stuff.
    Ms. Seidman. Right. And I think we have given you our 
opinion. I would just say that that third prong is I think an 
issue.
    Senator Dodd. I understand that. I thought I was making it 
relatively innocuous, in a sense. I am trying to do something 
that requires something other than just your signature and 
showing an ID to get $5,000 worth of credit.
    Ms. Seidman. Longer-term financial literacy training is the 
critical piece, to get that into the schools.
    Chairman Sarbanes. But this problem is growing. I think the 
Fed this morning had some release about the percent of 
disposable income now that is constituted in debt service 
payments. It is up to 14 percent, as I recall the figure.
    Chairman Greenspan. That is correct, Senator.
    Chairman Sarbanes. The average credit card debt per 
household, the Chicago Sun-Times reported, has grown over 
$8,000, three-fold in the past decade.
    Senator Dodd. They are kids.
    Ms. Seidman. They are kids.
    Senator Dodd. And we are looking for some guidance and 
help. We went through two bills and I heard nothing from 
regulators about the wisdom of putting some brakes on this 
thing here.
    Ms. Seidman. Senator, let me get back to you on this one.
    Chairman Sarbanes. Good.
    Senator Schumer.

             COMMENTS OF SENATOR CHARLES E. SCHUMER

    Senator Schumer. Thank you.
    Just one thing I would suggest about this at least to think 
about, is the same kind of rule that brokers have--a 
suitability rule be implemented for all kinds of loans, the 
student loans as well as the mortgages and all of that kind of 
thing, which would make some sense without nailing down what 
specifically had to be done.
    I think a suitability rule works, at least in the 
securities industry, and maybe should be applied to loans as 
well. And it is something to think about. I would like to 
address the first question to Chairman Greenspan.
    The question I most get asked, which of course relates to 
the health of financial industries, and that is, it seems that 
the reed--some would say thin reed. I am not sure that is 
right--that our economy is hanging on right now is consumer 
confidence, which, with all the buffeting that is gone on, has 
stayed at a reasonably decent level.
    The question I have, the question that I get asked more 
than any other, is, given the fact that layoffs have increased 
and accelerated over the last period of time, and people read 
about those and worry about those when they reach a certain 
level, how in general historically have layoffs affected 
consumer confidence? How direct a correlation is there?
    And second, does the present acceleration of layoffs or the 
recent acceleration of layoffs make one worry about consumer 
confidence levels, that even if the economy stayed where it is, 
that consumer confidence would decline with those layoffs and 
then cause the economy to go down further?
    Chairman Greenspan. Senator, most of the major estimates of 
consumer confidence, the proxies for actual psychological 
consumer confidence, if I can put it that way, employ some sort 
of measure of what either is the expected unemployment rate at 
some future point or whether you yourself or members of your 
family are likely to be laid off. And there is even one 
sophisticated one: what is the probability that you will be 
laid off ? So, they actually embody that specific notion within 
their statistical measure.
    There is no question that the issue of layoffs has to be a 
factor in determining the propensity of people to spend money 
to make a number of commitments which require the maintenance 
of an income.
    So the answer I would give to you is that, yes, layoffs do 
tend to impact on consumer confidence. We have had a 
significant pick-up in initial claims on insured unemployment, 
which is the broadest measure that we have on layoffs. It is 
doubtless impacting to a certain extent on consumer confidence, 
at least in the proxies that are effectively employed using 
that. But we have not yet seen any serious deterioration in the 
actions that people take.
    Senator Schumer. Right.
    Chairman Greenspan. And what you have to argue is that the 
ultimate measure of consumer confidence is not the statistical 
calculations we make about proxies of what tends to correspond 
to our judgments of consumer confidence, but what do people do?
    Senator Schumer. Right.
    Chairman Greenspan. So far, they have exhibited a fairly 
high degree of confidence. Consumer expenditures have not been 
going up in any material way, but they have held their own.
    Senator Schumer. The worry is that after month after month 
of people reading of these layoffs, worrying about them more in 
their own families, the neighbor down the street or whatever, 
that it affects the consumer's spending.
    Chairman Greenspan. That has been our history, Senator. And 
I think it is clearly an issue which we at the Federal Reserve 
watch very closely.
    Senator Schumer. But so far, we have not seen that--has the 
measure of layoffs accelerated over the last 3 months, that we 
would not see it yet even if it were going to occur, or has it 
been steady over the last 6 or 7 months?
    Chairman Greenspan. The rate of layoffs has gone up. In 
fact, as I said, the broadest measure we have of layoffs is 
initial claims and that, as you know, has gone from under 
300,000 a week to in excess of 400,000, so that all of the 
measures that we pick up on a weekly basis in those insured 
data--insured unemployment data systems--as well as our much 
broader employment series, does show a pick-up.
    Senator Schumer. I do not know what we can do about it 
here, although it relates to another question. But if one were 
looking generally at the economy, the level of worry one should 
have about consumer spending continuing should increase. It 
should be higher today than it was a few months ago.
    Chairman Greenspan. I agree with that and I think that is a 
correct view. But I think there is an interaction here which is 
also very complex.
    Senator Schumer. No question. Let me ask you this. Given 
the decline in productivity which we have discussed--
    Chairman Greenspan. The decline in the rate of growth in 
productivity.
    Senator Schumer. The rate of growth, although did not it 
actually decline in one quarter?
    Chairman Greenspan. It went down in the first quarter, but 
I would suspect that it will not be continuing in the second 
quarter.
    Senator Schumer. Given the decline in, at minimum, the rate 
of growth of productivity, and I hope you are right.
    Chairman Greenspan. I agree with that.
    Senator Schumer. Okay. And how important that is to long-
term growth, and this is the question that Evan Bayh asked, but 
should we be more worried today about the size of the tax cut, 
which I believe at some point you said had an effective rate 
higher than--actually would affect the budget higher than the 
1.35. I think you used, I read somewhere that you, I think, 
said it was closer to $2 trillion in its overall effect, given 
interest.
    Chairman Greenspan. I do not believe I said that.
    Senator Schumer. Strike that. No, I did not read it 
directly from you. I read it on a memo that you had said it and 
I had not read anywhere where you said it. So strike that.
    Chairman Greenspan. Let me just say this. I have never made 
such a calculation.
    Senator Schumer. Okay. Good. But given the change that we 
have seen in the economy over the last several months since the 
tax bill was proposed, not since it was signed, do we have 
greater worry about our status as a surplus government as 
opposed to a deficit government?
    Chairman Greenspan. It depends on what happens to the 
expenditure side of the budget.
    Senator Schumer. Let's say it grows at the rate of 
inflation.
    Chairman Greenspan. Well, clearly, if you take $1.35 
trillion out of the current services surplus, the actual 
surplus available for expenditures would be less than the 
current services surplus. I mean, that is arithmetic and I 
acknowledge that.
    Senator Schumer. No, no. But you are not worried at this 
point that we are going to, even though the economy is not as 
strong as when the initial tax cut was proposed, or even the 
$1.35 trillion was arrived at, you are not worried about us 
sliding back into deficit spending?
    Chairman Greenspan. I am not, Senator.
    Senator Schumer. You are more optimistic than I am. One 
more to the other two. What do you think of the suitability 
rule applying to borrowing, lending, as opposed to investment 
in securities? I would ask that of Mr. Hawke.
    Mr. Hawke. I think that is an interesting idea, Senator 
Schumer. But I am not sure that I would really like to see 
bankers making suitability judgments about the extension of 
credit beyond the basic kind of credit underwriting standards 
that I was talking about.
    I think the basic rules of sound credit extension subsume a 
suitability test. And that is, can the borrower service and 
repay the loan out of current resources without recourse to the 
collateral? If the lender makes that kind of judgment, I think 
that is basically what we need to assure that credit is not 
being pushed out to people who really cannot afford it. If you 
go beyond that and try to impose on bankers some judgmental 
responsibility for determining the purposes for which the loan 
is being taken out or other aspects of suitability of the sort 
that a registered broker-dealer might have to make under the 
securities laws, I think that raises other issues. But the 
basic standards of sound underwriting that have been 
traditional in the banking business for years provide a kind of 
suitability test, and if they were observed, I think that that 
would take us a long way.
    Chairman Sarbanes. Senator Carper.

              COMMENTS OF SENATOR THOMAS R. CARPER

    Senator Carper. Thanks, Mr. Chairman. I apologize for being 
late and missing all of your testimony and most of the 
questions. We have another hearing going on. The title of this 
hearing is the Condition of the U.S. Banking System. There have 
been times in the past 10, 20 years we could have said we are 
in some kind of crisis. There is another committee hearing 
going on today about the energy crisis in California and other 
parts of the country. And I apologize for not being here for 
this one. That seemed more of a crisis than we face in the 
areas that you oversee, so maybe that is good news.
    Chairman Greenspan, welcome back. And to our other 
panelists, thank you for joining us today. My wife is from 
North Carolina. And every Easter, we go down to North Carolina 
and we literally camp out in the wilds of North Carolina with 
her family, siblings, and their children. We were sitting 
around the camp fire back around Easter and heard a chilling 
story of identity theft involving the children of one of my 
wife's siblings, and how this has plagued her in her life for 
much of the last year, actually more than a year.
    Someone gave me a note here that said that a publication 
called the SAR (Suspicious Activities Reports) Activity Review 
reported some very large increase in the amount of reported 
identity theft and the impact that it has had on the lives of 
literally thousands of Americans. It seems to be a growing 
phenomenon. Having talked to someone who has lived through this 
for the past year or so, I am just wondering what can you do in 
your roles and what can we do in our roles to confront this 
growing concern?
    Chairman Sarbanes. Let me add to that, The Washington Post 
had an article just a few weeks ago--the Justice Department 
says that identity theft is one of the Nation's fastest-growing 
white collar crimes, just to underscore what Senator Carper is 
asking about.
    Mr. Hawke. I think that that is a very serious problem, 
Senator. We, and I believe the other agencies, just within the 
past few weeks, put out--I think it was quite a comprehensive 
advisory to banks on the need to have controls in place and to 
be alert to occasions when identity theft might be occurring. 
If financial institutions apply rigorous rules with respect to 
the access to information, it will help immeasurably, I think, 
in this regard.
    Banking institutions cannot be a complete bulwark of 
protection against identity theft because, in some instances, 
it is beyond the ability of the bank to control. But they can 
be vigilant, and they can be rigorous in the way they verify 
the identity of people who are opening accounts. They can 
certainly be vigorous in avoiding the disclosure of account 
information and other confidential information to people 
without very solid identification of the person to whom they 
are giving the information.
    Senator Carper. Please.
    Ms. Tanoue. I would just reiterate that all the agencies, 
including the FDIC, have issued guidance on identity theft.
    Senator Carper. Is this recent?
    Ms. Tanoue. I think during the past 5 months, yes. And that 
guidance does include information on measures that institutions 
can take to protect against stolen information. We would be 
happy to provide you a copy.
    Senator Carper. Thank you.
    Mr. Chairman.
    Chairman Greenspan. Senator, I think that what we are 
observing is probably an inevitable consequence of the 
tremendous increase in information technology. The very 
technology, however, that is creating the availability of a lot 
of this information which had not been available before to be 
absconded with, is also likely to be where the problem is going 
to be solved because we have very rudimentary mechanisms now 
for identification--Social Security numbers, driver's licenses, 
a variety of things which are so simple essentially to copy.
    We are invariably going to much more sophisticated means of 
identification. We already have them in a number of areas, 
obviously. And my impression is that until we move the 
technology into areas where it is very difficult to, for 
example, match eye prints or fingerprints or voice prints or a 
variety of things which are not simple things to copy, until we 
get to those levels, in my judgment, this is going to be an 
issue.
    I must admit, I was surprised at how fast the issue came 
up. And I think we are going to be dealing with it for a while. 
But I do think that the very emergence of it is probably going 
to put in place a good deal more of quasi-cryptographic means 
by which one can identify oneself and that should, hopefully, 
make it far more difficult to essentially steal somebody's 
identity for purposes of obtaining, usually relatively small 
cash awards.
    Senator Carper. Thank you for that. We have seen it in our 
own family, just from a personal perspective, what it does to 
an individual in their life. Obviously, as this threat grows or 
this level of criminal activity grows, it poses an increasing 
threat to our financial institutions as you well know.
    Chairman Greenspan. For example, we had the comparable 
issue in counterfeiting. It is not unrelated. We have made very 
significant advances in this area and I think much of the same 
type of approach is available to protect identities.
    Senator Carper. Mr. Chairman, I have one more question, if 
I could. And this is a short one. I was Governor when Congress 
was debating and adopting and the President was signing into 
law the Gramm-Leach-Bliley bill. But a number of folks 
predicted coming out of the adoption of that legislation that 
its enactment would lead to increased mergers between banks and 
insurers. So far, I do not think we have seen a great deal of 
that. And I would just like to know your thoughts about why, 
and if you expect to begin to see some increased merger 
activity that had been predicted.
    Chairman Greenspan. I think it is too soon in the sense 
that the regulatory structure is not in place, that these are 
very major moves on the part of institutions, and we will see 
them as time moves on and as we begin to integrate the statute 
into regulation and into the history which will enable 
individual institutions to make judgments as to whether in fact 
the regulatory climate which is available to them is conducive 
to an effective merger.
    Mr. Hawke. I think there are a couple reasons, Senator. As 
I talk to bankers and ask that same question--why there has not 
been more interest, for example, in acquiring insurance 
underwriters--they basically tell me they are not really very 
familiar with that business. It is a strange business to them, 
and the returns are quite different from those that bankers are 
looking at. And, looking at that from the other end of the 
pipeline, the insurance underwriters who presently do not own 
depository institutions may have some reservations about 
subjecting themselves to the regulatory environment that would 
be required.
    In the securities area, banks, as a result of rulings that 
the Federal Reserve made a number of years ago, have already 
been able to expand very significantly into a whole variety of 
securities activities. And again, looking at that from the 
other end of the pipeline, you have something of the same 
thing. Securities firms may not be acquiring depository 
institutions because of concerns about taking on another type 
of regulation that they are not presently subject to.
    The one area in which I think Gramm-Leach-Bliley has been 
particularly useful and successful is in expanding the 
opportunities for banks, large and small, all over the country 
to increse their insurance sales activities. If you talk to 
community bankers, that is one thing that they latch onto that 
was really important to them in Gramm-Leach-Bliley.
    Senator Carper. All right. Thank you all very, very much.
    Mr. Chairman, thank you.
    Chairman Sarbanes. Thank you very much, Senator Carper. I 
have a few questions that I want to ask as we draw toward a 
close. And of course, Senator Corzine has been here. He may 
want another round as well.
    First of all, Senator Corzine and I have both been very 
interested in this financial literacy and education issue. 
Actually, Chairman Greenspan, you gave a major speech on that. 
I think it would be helpful to us if we could get from each of 
the agencies, and this following a bit up on Senator Dodd as 
well, your view of how much of a need there is, how much of a 
shortfall there is with respect to financial literacy and 
education and what might be done about it. Both in a broader 
sense and even what your agencies might do in order to counter 
a problem of a lack of financial literacy and education, if in 
fact you perceive there to be one. I take it that most of you 
do. Would I be safe in saying that?
    Mr. Hawke. Mr. Chairman, I would say that basic financial 
literacy is certainly a concern. One element of that is the 
persistent resistance of many people to deal with commercial 
banks. This may not be an issue of financial literacy so much 
as something that is more sociological. But we see again and 
again in survey data that people are unwilling to deal with 
commercial banks for one reason or another. So, they use check 
cashers and fringe providers, payday lenders that are much more 
high-priced and do not have the ability to provide the same 
range of services. People will walk by a commercial bank to go 
to a payday lender right next door. One aspect of financial 
literacy that I think is very important is educating people and 
educating banks about how they can do a better job in reaching 
them.
    Chairman Sarbanes. We worked with Secretary Summers on that 
because he was quite interested in that issue and actually 
undertook some initiatives when he was Treasury Secretary in 
order to try to bank the unbanked, so to speak, or draw them 
into the financial mainstream. And they developed a number of 
programs at Treasury in order to try to do that. We are not 
certain yet whether this Treasury is going to continue down 
that path and seek to carry that through, but I think that is 
very important. All four of your agencies recently joined in 
issuing an advisory--I have the impression that the four 
agencies are working together in a more coordinated fashion 
than used to be the case. Is that an accurate impression or was 
it always the case?
    Chairman Greenspan. No, it is been up and down, Mr. 
Chairman. I think we are in an up stage at this point. But even 
on the down side, it works well in the sense that the 
alternative, which is basically to have a monopoly regulator, I 
do not think would serve this country well. So there are 
problems in the sense--I think Ellen Seidman mentioned it--we 
do not come to agreements immediately. We do not come to 
conclusions as quickly as some would like. So that there is 
friction and there is cost and there is probably excess 
conversation that goes on.
    But having said that, I think it is a very small price to 
pay for what is an extraordinarily effective regulatory system 
in this country. And it is encumbent upon all four of us to 
make certain we endeavor to find a center we can coalesce 
around. The goodwill in the process has been really quite 
measurable and I think quite effective.
    Chairman Sarbanes. Well, you issued this advisory:

    High on or off balance sheet growth rates are a potential 
red flag that may indicate the need to take action to ensure 
the risks associated with brokered or other rate-sensitive 
funding sources are managed appropriately.

    How serious is the problem. What actions are you taking, if 
any, other than issuing the advisory?
    Ms. Tanoue. This relates to the funding and liquidity 
issues that I think we have all testified about. We are working 
very closely to issue guidance like that through the FFIEC.
    In addition, we are watching the credit portfolios of the 
institutions very closely as they try to meet these funding and 
liquidity challenges.
    Mr. Hawke. Liquidity is a subject that we talk about with 
our banks all the time. We recently had a telephone seminar 
devoted entirely to liquidity. We had hundreds of banks around 
the country signed up, and it gave us the opportunity to 
address directly many of these concerns about liquidity.
    Chairman Sarbanes. I want to follow up on a question that 
Senator Bayh asked. And that is, we may look at our own system 
and say, well, it is in pretty good shape and it is pretty 
strong. But how severe is the risk to which we are exposed from 
a breakdown in the systems overseas? Japan has very serious 
problems right now from all reports. We had an Argentina scare. 
How exposed are we in this kind of world economy so that we 
must also have at the forefront of our worries the world 
context in which we are operating, no matter how much we may 
look at our own system here and say it is in pretty good shape. 
Something happens overseas, and the next thing we know, we have 
a major problem on our hands.
    Chairman Greenspan. Mr. Chairman, we are very conscious of 
that. And indeed, more importantly, so are the banks because a 
goodly part of their risk-management systems focus on 
addressing precisely the types of risks which you allude to. 
That is not to say that you can eliminate these problems very 
readily because, obviously, you are not only dealing with 
credit risk and the other risks we see domestically, but, very 
often you are dealing with exchange rate risk as well. And so, 
there are lots of possibilities for difficulties to emerge. 
There are lots of threats to the capital of the banking system 
as a consequence.
    But that is precisely what risk-management is all about. 
And what we endeavor to do in overseeing a number of our 
institutions, is to try to understand how they are addressing 
precisely this question. I am not saying that we can say with a 
great deal of certainty that we are perfectly secure. I do not 
think we can ever be secure. Indeed, banking is by its very 
nature risk-taking. But I do think we are acutely aware of the 
types of problems that can emerge, especially having been 
through the East Asian crises of 1997 and the Russian default 
shortly thereafter. So that there is not a long history behind 
us of tranquility in the international financial system. I 
hesitate to say that it is in complete control. It never will 
be. But I know of nothing which suggests to me that there is 
not a very significant amount of effort involved in both the 
banking system and in our supervisory system to make sure as 
best we can that these areas are covered.
    Chairman Sarbanes. Senator Corzine.
    Senator Corzine. Just an observation, I guess, as much as a 
question. But I would love your comments back. We talked mostly 
about sort of the macroelements of the condition of the banking 
system today. We got off here in the latter stages on financial 
literacy, which is one of those issues that impacts the overall 
soundness of the system--predatory lending, community 
development lending, money-laundering, the privacy issues that 
Senator Carper talked about.
    All of those issues tended not to be where you focused your 
testimony, but are issues and conditions. I wonder if there are 
things off of my list that I have left out. I would love to 
hear how all of you feel we are dealing with the issue, for 
instance, of money-laundering, which hasn't been talked about, 
which is a serious concern. I think some of the others we 
talked at least a little bit about-- community development 
lending, whether there is enough attention to that and whether 
you think there is a commitment in the private sector to 
addressing these sort of microissues as opposed to the 
macrorisk-management issues that have been major focus of the 
condition of the banking system. And I would ask any of you.
    Chairman Greenspan. Let me just start off, Senator, and 
say, the fact that you did not hear very much in our prepared 
remarks is indicative of the fact that we do not believe that 
those microissues are creating major safety and soundness 
problems with the commercial banks, which is important in and 
of itself. They are all very critical issues which all four of 
us spend perhaps almost an inordinate amount of time focusing 
on because they are quite difficult to deal with and difficult 
to come to the right conclusions on. None of them is simple. 
And in fact if they were, they probably wouldn't be problems.
    Jerry.
    Mr. Hawke. I would concur with that. Money-laundering is 
obviously a tremendously important issue. Money-laundering lies 
at the heart of drug trafficking. We have very strong 
regulations in place that require banks to have systems and 
controls that are aimed at identifying instances of money-
laundering.
    I think our people have done a very good job in alerting 
banks to the risks that are presented in that respect. These 
are not only broad risks that relate to drug trafficking, but, 
risks that relate to the banks themselves. So banks have a 
strong interest in assuring that they are not unwittingly 
implicated in other people's illegal conduct, and that is 
something we bear down quite heavily on.
    Ms. Tanoue. I would also add that within the time 
constraints, we only have a certain amount of space in our 
testimony and time to address the issues. Some of the issues 
that we are also addressing include the CRA regulatory review, 
for example, and I think the Committee would be interested 
probably in an update at some point soon in the status of that 
work.
    Senator Corzine. I am sorry?
    Ms. Tanoue. The CRA.
    Senator Corzine. The CRA, community development.
    Ms. Tanoue. Mr. Chairman, I did want to follow up on the 
question you had regarding financial literacy. I would mention 
that the FDIC has undertaken a very significant nationwide 
program on that front, called ``Money Smart,'' in conjunction 
with the Department of Labor, to offer education on financial 
programs to people outside the mainstream.
    Chairman Sarbanes. Can you submit us materials about that?
    Ms. Tanoue. Absolutely.
    Chairman Sarbanes. We would be very happy to have that.
    Senator Corzine. Thank you.
    Chairman Sarbanes. All right. Let me say it is my intention 
that at some point this year, the Committee will turn its 
attention to the money-laundering issue, which is a very 
important issue.
    Senator Carper, do you have anything else?
    Senator Carper. No. Thank you, Mr. Chairman.
    Chairman Sarbanes. Well, this has been a very good panel. 
We are most appreciative to you. Let me again underscore the 
fact that the written statements have obviously been prepared 
with a great deal of care and work and we appreciate having 
that, as well as your presence here today before us.
    Chairman Greenspan, we will be seeing you again next month 
when we do the monetary policy hearing and, as always, we look 
forward to that occasion.
    And we thank all of you for this contribution. We will 
continue to maintain this close relationship as we concern 
ourselves with the safety and soundness of our financial 
system.
    Thank you all very much.
    The hearing is adjourned.
    [Whereupon, at 12:40 p.m., the hearing was adjourned.]
    [Prepared statements, response to written questions, and 
additional materials supplied for the record follow:]
             PREPARED STATEMENT OF SENATOR PAUL S. SARBANES
    I am pleased to welcome this distinguished panel of witnesses 
before the Banking Committee this morning: Alan Greenspan, Chairman, 
Federal Reserve Board; Jerry Hawke, Comptroller of the Currency; Ellen 
Seidman, Director, Office of Thrift Supervision; and Donna Tanoue, 
Chair, FDIC.
    The purpose of today's hearing is to review the condition of the 
banking system of the United States. This hearing is not prompted by 
any triggering event or problem. Rather, the intention is to return to 
a prior practice of this Committee of holding periodic oversight 
hearings on the state of the banking system. By making this a regular 
event we would hope to elevate scrutiny of the system when times appear 
good and there may be a tendency toward complacency, as well as to 
defuse potential alarm when a hearing is held at a time that problems 
may exist. We would hope the regular scheduling of this hearing would 
be a useful discipline on the system and perhaps itself serve as a 
stabilizing influence.
    It appears that the past decade of economic growth has 
significantly strengthened the condition of the U.S. banking system. In 
my view the enactment by Congress of the Financial Institutions Reform, 
Recovery, and Enforcement Act (FIRREA) of 1989 in response to the 
thrift crisis, and the Federal Deposit Insurance Corporation 
Improvement Act (FDICIA) of 1991 in response to the commercial banking 
problems of the late 1980's and early 1990's, contributed to that 
improved condition. The capital and regulatory standards put in place 
by those statutes helped the system to take advantage of the growing 
economy of the 1990's. Improved coordination of supervision by the 
regulators also made a contribution.
    This morning we will hear from the regulators that the banking 
industry is better situated today to withstand a softening of the 
economy than it has been in the past. Banks have a greater variety of 
products and more geographic diversification in their assets. They have 
higher earnings, more capital, better risk-management techniques, and 
higher asset quality than in the past.
    Nevertheless they will also point out that asset quality problems 
have worsened for the past 2 years and loan loss provisions have 
increased substantially. Non-interest income of banks has been affected 
by a less robust economy and weaker stock market. Net interest margins 
declined for the sixth consecutive quarter to their 
lowest level since the first quarter of 1987. Loan losses continued to 
rise, with commercial and industrial loans accounting for more than 
half of the increase. The deterioration was concentrated among larger 
banks.
    The manufacturing sector has also been slowing down, which affects 
commercial loan quality. Increasing numbers of employees are being laid 
off, which is adversely affecting the quality of consumer loans. 
Sectors such as telecommunications, technology, and agriculture, and 
the banks that service them, are facing serious economic challenges. 
And consumers are more highly leveraged today than at any other 
measured point.
    The Committee will want to review all of these issues with the 
regulators this morning. Most fundamentally we will want to get an 
assessment from the regulators not only of how the system looks today, 
but how it may look 6 months or a year from now. The consensus forecast 
is that economic growth will pick up in the third and fourth quarters 
of this year and resume at a faster pace next year. If that is true, it 
will obviously have a beneficial impact on the banking system.
    However, that outcome is far from assured. If the economy remains 
weak for the rest of this year, what impact will that have on the 
banking system? How well equipped is the system to cope with a weak 
economy as well as a growing economy? These are some of the threshold 
questions we will want to explore with the bank regulators today. I 
look forward to hearing their testimony.

                               ----------
                  PREPARED STATEMENT OF ALAN GREENSPAN

       Chairman, Board of Governors of the Federal Reserve System
                             June 20, 2001

    Mr. Chairman and Members of the Committee, I am pleased to be here 
this morning to discuss the condition of the U.S. banking system. In my 
presentation today, I would like to raise just a few issues. I have 
attached an appendix in which the Federal Reserve Board staff provides 
far more detail relevant to the purpose of these hearings.
    There are, I believe, two salient points to be made about the 
current state of the banking system. First, many of the traditional 
quantitative and qualitative indicators suggest that bank asset quality 
is deteriorating and that supervisors therefore need to be more 
sensitive to problems at individual banks, both currently and in the 
months ahead. Some of the credits that were made in earlier periods of 
optimism--especially syndicated loans--are now under pressure and 
scrutiny. The softening economy and/or special circumstances have 
especially affected borrowers in the retail, manufacturing, health 
care, and telecommunications industries. California utilities, as you 
know, have also been under particular pressure. All of these, and no 
doubt other problem areas that are not now foreseeable, require that 
both bank management and supervisors remain particularly alert to 
developments.
    Second, we are fortunate that our banking system entered this 
period of weak economic performance in a strong position. After 
rebuilding capital and liquidity in the early 1990's, followed by 
several years of post-World War II record profits and very strong loan 
growth, our banks now have prudent capital and reserve positions. In 
addition, asset quality was quite good by historical standards before 
the deterioration began. Moreover, in the last decade, as I will 
discuss more fully in a moment, banks have improved their risk-
management and control systems, which we believe may have both 
strengthened the resultant asset quality and shortened banks' response 
time to changing economic events. This potential for an improved 
reaction to cyclical weakness, and better risk-management, is being 
tested by the events of recent quarters and may well be tested further 
in coming quarters.
    We can generalize from these recent events to understand a bit 
better some relevant patterns in banking, patterns that appear to be 
changing for the better. The recent weakening in loan quality bears 
some characteristics typical of traditional relationships of loans to 
the business cycle. The rapid increase in loans, though typical of a 
normal expansion of the economy, was unusual in that it was associated 
with more than a decade of uninterrupted economic growth. As our 
economy expanded, business and household financing needs increased and 
projections of future outcomes turned increasingly optimistic. In such 
a context, the loan officers whose experience counsels that the vast 
majority of bad loans are made in the latter stages of a business 
expansion, have had the choice of restraining lending, and presumably 
losing market share or hoping for repayment of new loans before 
conditions turn adverse. Given the limited ability to foresee turning 
points, the competitive pressures led, as has usually been the case, to 
a deterioration of underlying loan quality as the peak in the economy 
approached.
    Supervisors have had comparable problems. In a rising economy 
buffeted by competitive banking markets, it is difficult to evaluate 
the embedded risks in new loans or to be sure that adequate capital is 
being held. Even if correctly diagnosed, making that supervisory case 
to bank management can be difficult because, regrettably, incentives 
for loan officers and managers traditionally have rewarded loan growth, 
market share, and the profits that derive from booking interest income 
with, in retrospect, inadequate provisions for possible default. 
Moreover, credit-risk specialists at banks historically have had 
difficulty making their case about risk because of their inability to 
measure and quantify it. At the same time, with debt service current 
and market risk premiums cyclically low, coupled with the same 
inability to quantify and measure risk, supervisory criticisms of 
standards traditionally have been difficult to justify.
    When the economy begins to slow and the quality of booked loans 
deteriorates, as in the current cycle, loan standards belatedly 
tighten. New loan applications that earlier would have been judged 
creditworthy, especially since the applications are now being based on 
a more cautious economic outlook, are nonetheless rejected, when in 
retrospect it will doubtless be those loans that would have been the 
most profitable to the bank.
    Such policies are demonstrably not in the best interests of banks' 
shareholders or the economy. They lead to an unnecessary degree of 
cyclical volatility in earnings and, as such, to a reduced long-term 
capitalized value of the bank. More importantly, such policies 
contribute to increased economic instability.
    The last few years have had some of the traditional characteristics 
I have just described: the substantial easing of terms as the economy 
improved, the rapid expansion of the loan book, the deterioration of 
loan quality as the economy slowed, and the cumulative tightening of 
loan standards.
    But this interval has had some interesting characteristics not 
observed in earlier expansions. First, in the mid-1990's, examiners 
began to focus on banks' risk-management systems and processes; at the 
same time, supervisors' observations about softening loan standards 
came both unusually early in the expansion and were taken more 
seriously than had often been the case. The turmoil in financial 
markets in 1998, associated with both the East Asian crisis and the 
Russian default, also focused bankers' attention on loan quality during 
the continued expansion in this country. And there was a further 
induced tightening of standards last year in response to early 
indications of deteriorating loan quality, months before aggregate 
growth slowed.
    All of this might have been the result of idiosyncratic events from 
which generalizations should not be made. Perhaps. But at the same time 
another, more profound development of critical importance had begun, 
the creation at the larger, more sophisticated banks of an operational 
loan process with a more or less formal procedure for recognizing, 
pricing, and managing risk. In these emerging systems, loans are 
classified by risk, internal profit centers are charged for equity 
allocations by risk category, and risk adjustments are explicitly made.
    In short, the formal measurement and quantification of risk has 
begun to occur and to be integrated into the loan-making process. This 
is a sea change--or at least the beginning of one. Formal risk-
management systems are designed to reduce the potential for the 
unintended acceptance of risk and hence should reduce the procyclical 
behavior that has characterized banking history. But, again, the 
process has just begun.
    The Federal banking agencies are trying to generalize and 
institutionalize this process in the current efforts to reform the 
Basel Capital Accord. When operational, near the middle of this decade, 
the revised accord, Basel II, promises to promote not only better risk-
management over a wider group of banks but also less-intrusive 
supervision once the risk-management system is validated. It also 
promises less variability in loan policies over the cycle because of 
both bank and supervisory focus on formal techniques for managing risk.
    In recent years, we have incorporated innovative ideas and 
accommodated significant change in banking and supervision. 
Institutions have more ways than ever to compete in providing financial 
services. Financial innovation has improved the measurement and 
management of risk and holds substantial promise for much greater gains 
ahead.
    Building on bank practice, we are in the process of improving both 
lending and supervisory policies that we trust will foster better risk-
management; but these policies could also reduce the procyclical 
pattern of easing and tightening of bank lending and accordingly 
increase bank shareholder values and economic stability. It is not an 
easy road, but it seems that we are well along it.

              Appendix: Condition of the Banking Industry

  Prepared by: Staff, Board of Governors of the Federal Reserve System
                             June 20, 2001

    The U.S. banking industry is well capitalized and highly profitable 
by historical standards and in reasonably good shape, although there 
are signs of erosion as problem loans have risen, especially in larger 
syndicated credits. Moreover, some further erosion is likely as 
borrowers who have taken on heavy debt burdens experience less robust 
increases in profits and income than might have been anticipated not 
too long ago. In many cases, problem loans are a hangover from loans 
made in the mid-1990's when lenders evidently failed to exercise 
sufficient discipline. After about 1998, banks took a number of steps 
to tighten lending standards and terms, which should help to limit 
further deterioration. Nevertheless, with a weakening economy, problems 
could well worsen for some banks and some market segments, requiring 
vigilance by banks and their regulators. As always, the underlying 
issue is how to adopt and price realistic assessments of likely credit 
risks under alternative scenarios, keeping credit flowing to worthy 
borrowers at reasonable prices.
    Today, banking organizations and their supervisors are taking a 
number of steps that will be necessary to ensure that our financial 
system continues to flourish and support long-term economic growth well 
into the future. Key elements of such actions are referenced in the 
last two sections of this appendix.

Earnings
    Although banking profitability has risen to historically high 
levels in terms of return on assets and return on equity over the past 
decade, in recent periods higher loan loss provision expenses and 
narrowing net interest margins have placed pressures on bank 
profitability. Despite those emerging weaknesses, downside risks likely 
have been limited by the increasing diversity of noninterest and 
interest sources of revenues. The continued push by banks to diversify 
their revenues by expanding business lines devoted to asset management, 
servicing, securitization, investment banking, and other fee-based 
activities should help stabilize earnings streams. In addition, in the 
wake of consolidation and interstate banking, many larger firms are 
less vulnerable to downturns in particular regions or specialized 
business lines.
    Nonetheless, in the past few quarters, emerging earnings weaknesses 
have been pronounced at some of the larger banking organizations, which 
have experienced sharp increases in loan loss provision expenses, 
narrowing interest margins, and significant declines in venture capital 
revenues. During the first quarter of this year, those negative 
developments at large firms were somewhat offset by record trading 
profits and better overhead cost efficiency. While the net effect was a 
decline in profits at many larger banking organizations, the underlying 
strength in the profitability of regional and community banks, coupled 
with nonrecurring securities gains, helped the industry as a whole 
achieve record first quarter earnings of nearly $20 billion.

Asset Quality
    The rise in nonperforming assets at banking organizations has been 
pronounced over the past year, especially at larger banking 
organizations. Despite that rise, these problems generally remain 
moderate in historical terms relative to earnings, assets and capital. 
Assets classified as substandard, doubtful or loss have also risen 
rapidly in recent periods, though again from a modest base. Much of 
that increase is attributable to larger syndicated credits, though 
there are some indications of softening in the credit quality of 
middle-market borrowers. In response to this rise, banks have written 
down assets to estimated net realizable values and replenished reserves 
for expected problems through loan loss provision expenses.
    A common theme for many of the problem credits has been significant 
leverage employed to expand businesses during times of ebullient 
economic and market conditions. Many of these credits were originated 
during a period of relaxed lending standards that did not adequately 
account for the susceptibility of the borrower to weakening sectoral or 
economic conditions. After the reminders in 1998 from the Asian 
disruptions and the Russian default, lending standards were tightened. 
But, with the advent of a softening economy, the embedded risks of 
weaker or more vulnerable borrowers are becoming well recognized. 
Particularly hard hit have been certain borrowers in the retail, 
manufacturing, health care and telecommunications industries. In 
addition, unexpected developments in asbestos litigation as well as the 
difficulties faced by the California utilities have also added 
considerably to the stock of classifications.
    The rapid deterioration of credit quality in certain segments of 
bank loan portfolios reflects the significant share of the growth in 
bank lending in recent years to borrowers on the borderline between 
investment and noninvestment grade creditworthiness. With the presence 
of active money and capital markets in the United States, and their 
ease of access by the best quality borrowers, these credit grades 
reflect the quality of those with which our banks now normally deal. 
They represent the types of borrowers that tend to require the more 
customized analysis, underwriting and structuring offered by banks that 
may not be as readily available or as cost-effective through the bond 
market. The higher magnitude and volatility of default rates in these 
types of borrowers is well documented from decades of experience in the 
below-investment grade segment of the bond market. Consequently, as 
conditions have weakened and defaults have risen sharply in 
noninvestment grade bonds, a parallel increase has occurred in troubled 
and nonperforming loans of bank portfolios. Forecasts for a continued 
rise in defaults for lower rated bonds by Moody's suggest that bank 
corporate asset quality is also likely to deteriorate further before it 
improves.
    Although part of the deterioration may be a natural consequence of 
taking normal business risk in a weaker economy, part also reflects a 
lack of discipline by some banks, particularly in the 1995-1997 
interval. As banking organizations relaxed their standards and the 
rigor of their credit risk analysis in this period, banking supervisors 
responded by issuing cautionary guidance and stepped up the intensity 
of reviews of lending operations at many banking firms. In particular, 
supervisors pointed out the need for lenders to avoid the use of overly 
optimistic assumptions that presumed strong conditions would prevail 
indefinitely. In addition, supervisors also noted the lack of downside 
risk analysis or stress testing as a weakness in risk-management 
practices at many banks.
    Recent credit losses have highlighted the importance of following 
those sound lending and evaluation fundamentals and have clearly 
differentiated strong credit risk-management systems from weak ones, 
prompting many organizations to take remedial action. For the past 
several years, the banking agencies have shifted their supervisory 
approach to focus on risk-management processes at banking organizations 
as a more effective means for promoting sound banking practices. While 
bank risk-management practices have improved, in part because of 
supervisory efforts, recent experience has shown that more work needs 
to be done. More recently, to help facilitate improvements underway at 
banks in response to current credit difficulties, the banking agencies 
issued guidance earlier this year clarifying their expectations 
regarding sound practices for managing leveraged finance exposures.
    Even before recent weaknesses, banks had begun to reevaluate their 
strategic direction and, with the encouragement of supervisors, had 
become more deliberate about the need to implement formal procedures 
for recognizing, pricing, and managing risk. Without these reforms, the 
recent deteriorating trends would likely have been considerably worse. 
In these emerging systems, loans are classified by risk, internal 
profit centers are charged for equity allocations by risk category, and 
risk adjustments are explicitly made. In addition, more advanced 
systems provide the metrics that are necessary to support active 
portfolio management, including decisions on whether certain loans 
exhibiting emerging weaknesses should be sold and at what price. The 
active sale of troubled syndicated credits has been an emerging trend 
among larger organizations. In particular, the increasing appetite for 
these loans by nonbank investors has helped deepen and liquefy the 
market, providing an outlet for banks with adequate capital and 
reserves to sell loans at a discount to par value and to rebalance 
their portfolios.
    Today risk-management systems have also helped rationalize the 
pricing of risk through stricter terms and conditions for more 
vulnerable borrowers. Sophisticated risk-management systems are also 
helping banks to reevaluate the profitability of bank lending by 
benchmarking loans against corporate hurdle rates. In many 
circumstances, banks are recognizing that without the ancillary cash 
management or other revenue opportunities attached to the lending 
relationship, it is difficult to find stand-alone lending opportunities 
that meet these hurdle rates. By using these sophisticated quantitative 
risk-management tools to support their decisionmaking, banks are better 
able to distinguish profitable versus unprofitable relationships and 
determine if a particular customer is compatible with the bank's 
appetite for risk.
    At present, the tightening of terms and standards at banks and the 
bond market has not inhibited the flow of funding to sound borrowers, 
though borrowers appear to be increasingly tapping the bond market, and 
lenders and the bond market also are requiring higher spreads for 
marginal credits. While tightening can be over done, so far banks seem 
to be making balanced decisions on the tradeoff between risk and 
returns. This is a favorable outcome, because it assists in directing 
capital flows to their highest and best use in the economy.
    Much focus has been placed on the dynamics within the corporate 
loan book, which is currently experiencing the majority of problems, 
but banks and supervisors should continue to be vigilant for other 
potential risks. In particular, though retail credit quality has been 
fairly stable in recent years, consumers, like corporations, have also 
increased leverage, making their ability to perform under stressful 
circumstances less reliable. In recent years, buoyant economic 
conditions raised expectations for continued growth in income and 
employment for consumers, which along with rising levels of wealth, has 
led to growth in household debt that has outstripped growth in 
disposable personal income over the past 5 years. That expansion of 
debt has pushed consumer debt service burdens to new highs.
    With the recent slowdown in the economy, rising personal 
bankruptcies, an increasing unemployment rate, and a modest 
deterioration in loan quality, lenders have tempered their outlook, 
tightening their standards somewhat for credit cards and installment 
loans. At the same time, while consumer spending has leveled as the 
economy has weakened, demand for credit has strengthened in recent 
periods.
    Over the past decade, banking organizations have taken advantage of 
scoring models and other techniques for efficiently advancing credit to 
a broader spectrum of consumers and small businesses than ever before. 
In doing so, they have made credit available to segments of borrowers 
that are more highly leveraged and that have less experience in 
managing their finances through difficult periods. For the most part, 
banks appear to have tailored their pricing and underwriting practices 
to various segments of their consumer portfolios to account for the 
unique risks related to each. Some institutions have also tailored 
lending toward segments with troubled credit histories, the so-called 
subprime market. Such lending can be favorable both to borrowers and 
lenders. Subprime borrowers benefit by gaining access to credit and the 
opportunity to build a sound credit history that may eventually allow 
them to achieve prime status. For lenders, subprime lending affords the 
opportunity for higher returns provided the necessary infrastructure is 
in place to closely track and monitor the risk related to individual 
borrowers, which can be labor intensive and costly. Lenders must also 
recognize the additional capital and reserve needs to support such 
lending, particularly if they have concentrations in subprime loans.
    Banks that have not understood the subprime market have had 
significant difficulties. To ensure that banks entering this business 
properly understand these risks, the agencies have encouraged banks to 
adopt strong risk-management systems tailored to the challenges posed 
by these loan segments. Beyond poor risk-management, there have also 
been instances in which certain lenders have charged fees and 
structured loans designed not to protect against risk, but rather to 
deceptively extract a borrower's net worth. Such predatory lending 
practices, though rare, are a cause for concern and examiners are 
watchful for programs that would violate the law in this regard.
    Another area of supervisory focus, of course, is commercial real 
estate. The exceptional demand for office and other commercial real 
estate in recent years has led to a rebound in the volumes of loans 
secured by these properties. This time, however, as demand has grown, 
larger banking organizations have managed to keep their holdings modest 
relative to their asset bases either through securitizations, sales or 
by avoiding originations altogether. In contrast, many smaller 
commercial banks have raised their commercial real estate 
concentrations relative to assets and capital. While underwriting 
practices appear to be much healthier today than they were in the 
1980's and standards have tightened somewhat recently, supervisors are 
paying particular attention to community banks with concentrations that 
make them materially vulnerable to a downturn in this market.
    While for the past several years there have been few real estate 
markets with material imbalances in supply and demand, emerging signs 
of weakness make the need for vigilance more pressing. In the first 
quarter of this year, there has been a pronounced increase in 
nationwide vacancies that has resulted in a negative net absorption of 
office space in the United States. That poor performance, the worst in 
20 years, has been attributed by some market observers to the abrupt 
return of office space to the market by technology firms and to delays 
by prospective tenants hoping that softening conditions will lower 
rents further. In this environment, noncurrent commercial real estate 
loans have edged up somewhat in the first quarter. Whether the first 
quarter represents a temporary phenomenon or the beginning of a longer 
term trend remains to be seen, but the need for institutions to 
continue a realistic assessment of conditions and stress test their 
portfolios is paramount.
    In addition to real estate, agricultural lending is also facing 
challenges. Commodity price weakness, coupled with changes in the 
Federal price support programs, has placed pressures on the ability of 
farmers to service their debt. This in turn has led to a rise in 
noncurrent farm loans. Banks are continuing to identify ways to work 
with their borrowers to navigate through this difficult period.

Funding
    For banks to remain in sound condition, they must not only pay 
attention to the quality of their assets, but also to the nature and 
quality of their funding. In recent years, large and small banks alike 
have come to rely increasingly on large wholesale deposits and 
nontraditional sources of funds. They have done so in part as the 
demand for loans and their own growth objectives have outstripped the 
growth in insured core deposits. It is true that retail core deposit 
growth has been quite meager over the past decade with higher returns 
in mutual funds and the stock market luring customers away from banking 
deposits. On the other hand, banks have also made the calculated 
decision to pay relatively low-interest rates on some types of retail 
accounts and rely on higher-priced jumbo deposits or wholesale 
borrowing to fund incremental asset growth.
    Despite competition for household funds, community banks have been 
relatively successful at maintaining their core deposit bases. For 
example, a decade ago banks with less than $50 million in assets funded 
around 80 percent of their assets with core deposits. Over the course 
of the past decade, that figure eroded by 7 percentage points, but 
remains a fairly strong 73 percent of assets. That compares to core 
deposit holdings of only 39 percent for banks with more than $10 
billion in assets.
    While community banks have experienced moderate erosion in the 
share of core deposits funding assets, when that trend is coupled with 
rapid loan growth, pressures on bank liquidity have intensified. To 
replace core deposits, community banks have been fairly successful at 
attracting jumbo deposits and have made use of Federal Home Loan Bank 
advances. Community banks have also funded the gap between loan and 
deposit growth by liquidating securities holdings and accordingly 
raising the quantity of loans relative to assets. The combined deposit 
and loan trends have pushed liquidity benchmark ratios such as loans-
to-deposits to historic peaks. On the other hand, there are some signs 
of relief for bank liquidity. For one, the demand for loans by 
businesses and consumers appears to be moderating, and there are some 
early indications that consumers are returning to bank retail deposits 
in the wake of disappointing stock and mutual fund results.
    Still, many of these liquidity pressures are likely to remain in 
one form or in another, and banks are likely to continue to explore 
nondeposit alternatives for managing their balance sheets. While the 
use of nondeposit liabilities to fund growth is not new to banks, the 
growing volume, variety and complexity of these funds creates new 
issues. To meet this challenge, banks must strive to fully understand 
the implication of relying on these types of funds both from a 
liquidity and earnings perspective. The Federal Reserve recently issued 
guidance on the use of complex wholesale borrowings and the banking 
agencies recently issued guidance on rate sensitive deposits to 
highlight the importance of adequate management techniques for ensuring 
stable and consistent funding.

Capital and Supervisory Initiatives
    The most stable funding source for bank balance sheets is 
shareholder equity. More significantly, shareholder equity's key 
feature is its ability to absorb losses. The need for banks to hold 
capital commensurate with the risk they undertake is highlighted by 
recent weaknesses in bank asset quality and the uncertain economic 
environment. Today, by virtue of market pressures following the 
difficulties of the late 1980's, minimum regulatory capital 
requirements and the ability of many banking organizations to measure 
and recognize their own needs for a cushion against more difficult 
times, the industry capital base appears adequate to meet emerging 
challenges. From a regulatory capital perspective, the vast majority of 
all banks meet the definition for well capitalized.
    The original Basel Accord that was adopted in 1988 has served 
supervisors and the industry fairly well over the past decade as one of 
the primary tools for maintaining a sound banking system. More 
recently, the nature and complexity of risk undertaken by many larger 
organizations have made the blunt traditional measures of capital 
adequacy, whether equity-to-assets, leverage, or current risk-based 
capital ratios, less meaningful. In considering the likely continuation 
of innovations over the next decade, supervisors must develop ways to 
improve their tools while reinforcing incentives for sound risk-
management.
    The new Basel risk-based proposal seeks to achieve the twin 
objectives of a more meaningful capital adequacy measure and promoting 
sound risk-management practices. The proposal by the Basel Committee 
that was announced in January of this year calls for an international 
capital accord that is based on three pillars: a minimum capital 
requirement that is more sensitive to risk, a supervisory review 
process, and market discipline. It is important to note that the Basel 
Committee is in the process of reviewing the public's comments on the 
proposal and there are still a myriad of important issues and details 
to address and work out before it can be implemented.
    The proposal offers a menu of alternative frameworks for 
establishing minimum capital requirements so that institutions can be 
matched with the approach that fits their particular degree of 
sophistication, risk profile and risk-management capabilities. On one 
end of the spectrum, the proposed advanced approach, designed for the 
most sophisticated and complex entities, relies on a bank's internal 
risk rating and loss estimates in the establishment of the minimum 
requirements for credit exposures. At the other end of the spectrum, 
the proposed standardized approach modifies the current framework to be 
somewhat more risk sensitive but retains many of the simple features of 
the current accord.
    The second pillar, the supervisory review process, requires 
supervisors to ensure that each bank has sound risk-management 
processes in place. The emphasis in that review is both on the 
integrity of the process that produces the metrics used in calculating 
the supervisory minimum, as well as the adequacy of a bank's own 
analysis of its capital needs.
    The second pillar fits very well with the Federal Reserve's efforts 
in recent years to encourage larger, more complex banks to improve 
their internal risk rating systems while placing more emphasis on their 
own internal analysis of capital adequacy. The new accord is much more 
than an effort to improve the meaningfulness of minimum regulatory 
capital ratios, although that clearly is an important aspect of the 
proposal. Embodied in the proposal are some important risk-management 
principles and sound practices that supervisors would expect all of the 
very largest and most complex U.S. banks to be following or aspiring 
to, even those not electing to use one of the more advanced approaches. 
As proposed, the capital standards should provide banking organizations 
in the United States and abroad with strong incentives to accelerate 
their development and implementation of improved risk-management 
systems in order to qualify for a more risk sensitive regulatory 
capital treatment. Moreover, the review necessary to ensure that bank 
risk measures are sound maintains the focus of supervisors on the key 
elements of control and risk-management that govern safe and sound 
banking.
    The third pillar complements the first two by bolstering market 
discipline through enhanced disclosures by banks. By their very nature, 
many banking risks are opaque. However, innovations in recent years 
that have helped improve the management of risk have also led to the 
development of various summary statistics to meaningfully describe 
risks that were qualitatively described in the past. While challenges 
remain in making such measures comparable or differences across 
institutions well understood, such disclosures are a necessary 
complement to the other two pillars for the overall approach to retain 
the necessary level of rigor and integrity. Disclosure of information 
that helps stakeholders determine risk profiles is designed, of course, 
to increase, when necessary, the market pressure and costs on bank 
lenders that they would otherwise receive as a matter of course if they 
were not beneficiaries of the safety net. Market discipline can also 
provide useful signals to supervisors.
    Significantly, the opportunity for enhanced market discipline 
through disclosure is substantial given that larger organizations fund 
about two thirds of their assets with uninsured funds. However, 
supplemental information will be irrelevant unless uninsured creditors 
believe that they are, in fact, at risk. Uninsured creditors have 
little reason to engage in risk analysis, let alone act on such 
analysis, if they believe that they will always be made whole under a 
de facto too-big-to-fail policy. Recognizing that dilemma, in 1991 the 
Congress placed in the Federal Deposit Insurance Corporation 
Improvement Act a requirement for a least-cost resolution of financial 
institutions. Although an exception clause exists, it does not require 
that all uninsured creditors be made whole. Conceptually, there are 
rare situations where events may require that the FDIC and other 
governmental resources be used temporarily to sustain a failing 
institution pending its managed liquidation. But indefinitely propping 
up insolvent intermediaries is the road to stagnation and substantial 
resource misallocation, as recent history attests.
    Indeed, if the Government protects all creditors, or is generally 
believed to protect all creditors, the other efforts to reduce the 
costs of the safety net will be of little benefit. The implications are 
similar if the public does not, or cannot, distinguish a bank from its 
affiliates. As financial consolidation continues, and as banking 
organizations take advantage of a wider range of activities, the 
perception that all creditors of large banks, let alone of their 
affiliates, are protected by the safety net is a recipe for a vast 
misallocation of resources and increasingly intrusive supervision.

Financial Holding Companies and Umbrella Supervision
    Mindful of the potential for the Federal safety net to extend 
beyond what Congress intended in its enactment of the Gramm-Leach-
Bliley Act (``GLB Act''), the Federal Reserve has been careful to 
distinguish between insured depositories and uninsured holding company 
affiliates and parent organizations in the supervision of financial 
holding companies (``FHC's''). Consequently, the Federal Reserve's 
focus in FHC supervision has been to identify and evaluate, on a 
consolidated group-wide basis, the significant risks that exist in a 
diversified holding company with a view to evaluating how such risks 
might affect the safety and soundness of insured depository institution 
subsidiaries. Such supervision is not intended to impose bank-like 
supervision on FHC's, nor is it intended to duplicate or replace 
supervision by the primary bank, thrift, or functional regulators of 
FHC subsidiaries. Rather, it seeks, on the one hand, to balance the 
objective of protecting the depository institution subsidiaries of 
increasingly complex organizations with significant interrelated 
activities and risks, against, on the other, the objective of not 
imposing an unduly duplicative or onerous burden on the subsidiaries of 
the organization.
    To accomplish that objective we have relied on our long-standing 
relationships with primary bank, thrift, securities, and foreign 
supervisors while forging new relationships with the functional 
regulators that oversee activities that are newly 
permitted under the Act. These relationships respect the individual 
statutory authorities and responsibilities of the respective 
supervisors, but at the same time, allow for enhanced information flows 
and coordination so that individual responsibilities can be carried out 
effectively without creating duplication or excessive burden. The 
Federal Reserve places substantial reliance on internal management 
information maintained by FHC's and on reports filed with, or prepared 
by, bank, thrift, and functional regulators, as well as on publicly 
available information for both regulated and nonregulated subsidiaries.
    Since enactment of the GLB Act, over 500 FHC's have been formed. 
The vast majority of those are small community holding companies that 
converted largely in an effort to take advantage of the insurance 
agency provisions of the GLB Act or to be well positioned should 
opportunities for exercising new powers present themselves. Most of the 
larger holding companies have also converted to FHC's, and appear to be 
taking advantage of the securities, merchant banking, and to a lesser 
extent, the insurance provisions of the Act. In addition to the 
conversion of existing bank holding companies, there have been a few 
nonbank financial service companies that have applied for and received 
FHC's status in connection with their acquisition of banking 
organizations.
    In general, banking organizations appear to be taking a cautious 
and incremental approach to exercising new powers under the GLB Act. In 
addition, the number of new, truly diversified financial holding 
companies across securities, insurance and banking has been few enough 
to let organizations and supervisors gradually gain experience and 
comfort in their operations.

                               ----------

                 PREPARED STATEMENT JOHN D. HAWKE, JR.

      Comptroller of the Currency, U.S. Department of the Treasury
                             June 20, 2001
Introduction
    Mr. Chairman, Senator Gramm, and Members of the Committee, I 
appreciate this opportunity to discuss the condition of the banking 
system. I am pleased to report that the last decade has been a period 
of economic prosperity and strong growth in the banking sector. 
Commercial bank credit grew by over 5 percent per annum during the 
1990's. During this period of prosperity, most banks strengthened their 
financial positions and improved their risk-management practices.
    As a result, the national banking system is in a much better 
position to bear the stresses of any economic slowdown. National banks 
are reporting strong earnings with a return on equity (ROE) for the 
first quarter of this year of 15.2 percent--a level considerably higher 
than the ROE of 11.5 percent prior to the last economic slowdown in 
1990-1991. Fifty-five percent of banks reported earnings gains from a 
year ago. Asset quality for the national banking system is better. The 
ratio of noncurrent loans (for example, 90+ days past due and 
nonaccrual) to total loans is 1.3 percent, compared to 3.3 percent in 
the first quarter of 1990, the year marking the start of the last 
slowdown. And capital levels are at historical highs. As of the first 
quarter of 2001, the ratio of equity capital to assets was 8.9 percent, 
compared to 6.0 percent in the first quarter of 1990.
    As we move into the next decade, banks and bank supervisors face 
two major challenges. The first is cyclical: how to identify and manage 
the risks associated with a slowing economy in the United States and 
internationally. Many nonbank companies are experiencing a slowdown in 
demand for their products and services. This in turn is prompting a 
scaling back of expansion plans and staff reductions, which invariably 
will have regional and local economic repercussions for a variety of 
bank lending and servicing activities.
    The second challenge is structural: how to adapt bank operations 
and supervision to the fundamental long-term changes in the banking 
industry. The rapid changes in technology, the increased competition in 
the market for financial services providers, and the globalization of 
financial markets are all presenting significant strategic and 
operational challenges for bank management and regulators.
    My remarks today will cover four main topics. First, I will discuss 
the current state of the national banking system. Second, I will 
describe how the national banking system today compares with 1990, just 
before the last economic slowdown. I will then highlight the emerging 
risks and trends, and I will end with a discussion of the steps that 
the OCC has taken and will continue to take to address those risks.

The Current State of the National Banking System
    The 1990's were a period of extraordinary earnings for the banking 
industry. National banks reported record earnings for 8 consecutive 
years as net income rose from $17.3 billion in 1992 to $42.6 billion in 
1999. During this period, the annual return on equity averaged 15.2 
percent, peaking in 1993 at 16.4 percent [see Figure 1].
    Greater diversification of income sources improved the quality of 
bank earnings during the 1990's. This diversification trend should 
improve the capacity of banks to weather difficult economic times and 
better manage the risks embedded in their operations. For example, the 
share of banks' revenues coming from noninterest income sources such as 
fee income, asset management and trust services, brokerage and trading 
activities and fiduciary income increased over the last 10 years from 
34 percent to over 45 percent [see Figure 2]. The trend away from 
reliance on traditional interest income is in part an active effort by 
banks to better manage risk. As a supervisor, we strongly support the 
efforts of national banks to diversify their revenue streams through 
financially related activities.
    The search for new sources of revenue also reflects an effort to 
offset the effects of increased competition in traditional lending 
activities from nonbank competitors. Interest income grew at the modest 
rate of 5 to 6 percent during this period, largely as a consequence of 
loan growth. During most of the 1990's, banks' net interest margins 
(the spread between what a bank earns on loans and investments and what 
it pays for funds) declined, a trend that is unlikely to be reversed. 
Because they expect continuing margin declines and slowing growth, 
banks have turned to alternative sources of revenue.
    Slow revenue growth may become an issue for banks in 2001 if slower 
economic growth and weakening equity markets continue. Noninterest 
income is likely to be subdued and bank lending is likely to be 
sluggish. The most recent Federal Reserve Beige Book published last 
week reported declining loan demand in many of the Federal Reserve 
Districts as firms in a variety of industries have cancelled or 
postponed plans to expand and in some cases are laying off employees.
    Another key determinant of the profitability of the banking system 
is the quality and performance of its loans. One useful measure of 
asset quality is the level of noncurrent loans--those loans with 
payments past due at least 90 days or in nonaccrual status, when any 
payments received by the bank are used first to pay down principal. The 
ratio of noncurrent loans to total loans, which was 4.1 percent in 
1991, fell steadily to less than 1 percent in the late 1990's [see 
Figure 3]. The low level of noncurrent loans meant that banks were able 
to divert a relatively small amount of their revenue each year to loan 
loss reserves, which in turn boosted earnings.
    The deterioration in credit quality, particularly in the commercial 
and industrial (C&I) loan portfolio, began 3 years ago and picked up 
steam in 2000. The noncurrent ratio for C&I loans for large banks 
increased by 56 basis points last year. While overall credit quality 
deterioration was more modest for smaller banks, rising only 3 basis 
points in 2000, these nationwide aggregate ratios understate the impact 
that the slowdown in economic growth is having on small bank credit 
quality in some geographic areas.
    Spurred by the slippage in asset quality in 2000, particularly for 
C&I loans at large banks, the dollar value of loss provisions (the 
additions to loan loss reserves) rose 32 percent over the previous 
year. The ratio of provisions to loans rose to 0.95 percent, its 
highest rate since 1993. The rise in provisioning was most pronounced 
at the large banks and credit card banks, but provisioning at smaller 
banks also increased to its highest rate since 1993. Nonetheless, 
provisioning remains below the rates experienced during the banking 
turmoil of the 1980's and early 1990's.
    The weakening in credit quality indicators and slowing of the 
economy increases the likelihood that banks will increase the level of 
provisioning in coming quarters to cover inherent loan losses. Prior to 
the 1990-1991 recession, loan loss reserves, as a percentage of total 
loans at national banks, were 2.5 percent, rising to a peak of 2.8 
percent in 1992. During the current expansion, by contrast, the 
industry-wide loss reserve ratio for national banks declined to 1.8 
percent. While loan loss reserves as a percentage of loans have 
remained fairly stable at 1.8 percent for the last 2 years, the 
coverage ratio of reserves to noncurrent loans has fallen from 184 
percent to 138 percent. If the economy continues to slow, causing a 
further deterioration in credit quality, banks will be expected to 
increase their level of reserves.
    The record earnings of the 1990's and good asset quality enabled 
national banks to build their capital. The ratio of equity capital to 
assets for all national banks rose to 8.9 percent at the end of the 
first quarter of 2001, the highest level in nearly four decades [see 
Figure 4]. Nearly 98 percent of all national banks met the regulatory 
definition of well capitalized by maintaining a ratio of equity capital 
to assets above 5 percent and a total capital to risk-based assets 
above 10 percent.

Comparison With Prior Economic Slowdown
    With the slowing of economic activity in the United States and the 
potential for increased financial stress on banking institutions, it is 
worthwhile comparing the current condition of national banks to 
conditions that existed just prior to the recession of the early 
1990's. Indeed, mindful of the stresses that many commercial banks 
experienced in the late 1980's, that point is a constant frame of 
reference for us as we approach today's supervisory challenges.
    For the national banking system as a whole, profitability, asset 
quality and capitalization are significantly stronger today than in 
1990 [see figure 5]. For example, median income as a percentage of 
assets (return on assets, or ROA) was 14 basis points higher in the 
first quarter of 2001 than in the same period in 1990. The median ratio 
of noncurrent loans to total loans was 92 basis points lower and the 
median capital ratio was 160 basis points higher.
    The proportion of the banking industry facing the economic slowdown 
from a position of weak performance is substantially less than in 1990 
just prior to the last recession. For example, less than 1.5 percent of 
the banks currently have an equity capital ratio under 6 percent. In 
1990, 17 percent of banks had an equity capital ratio under 6 percent.
    Banks have also made gains during these years in diversifying 
risks. Loan securitization has become a significant funding tool, 
enabling banks to generate revenues from loan origination while 
shifting credit and interest rate risk off of their balance sheets. 
Banks have also broadened the geographic scope of their operations and 
increased the range of financial services they offer, providing them 
with a greater capacity to weather adverse economic developments. 
Advances in information technology have provided bank managers with 
advanced risk-management tools that were unavailable a decade ago.

Emerging Risks
    While the national banking system is in a stronger position 
relative to the last economic slowdown, banks cannot be complacent 
about the risks that will continue to surface in the current economic 
environment, particularly in the areas of credit and liquidity.

Credit Quality
    While the level of loan losses is still relatively low, since 1997 
the OCC has been concerned about a lowering of underwriting standards 
at many banks. This relaxation of standards stems from the competitive 
pressure to maintain earnings in the face of greater competition for 
high-quality credits, particularly from nonbank lenders. In some cases, 
banks' credit risk-management practices did not keep pace with changes 
in standards. We now are beginning to see the consequences of those 
market and operational strategies in the rising number of problem 
loans.
    The deterioration in credit quality indicators that began 3 years 
ago has to date been largely concentrated in the C&I loan portfolios of 
the larger banks [see Figure 6]. The Asian financial crisis and the 
turmoil in the capital markets in the fall of 1998 also put pressure on 
large banks' loan portfolios. As capital markets contracted and the 
cost of debt became more expensive, corporations turned to the banking 
sector for an increasing share of their financing needs. This shift 
accounts, in part, for the substantial growth rates that banks have 
experienced in C&I lending, leveraged financing, and commercial real 
estate and construction financing. While such lending resulted in 
strong growth in the banking sector, competition to book these loans 
also put pressure on banks' underwriting and risk-management controls.
    Emerging credit risk is not just an issue for large banks. As 
corporate earnings have weakened, the spillover effects on credit 
portfolios are beginning to show up in the smaller institutions. 
Community banks (defined as banks with assets under $1 billion) in 33 
States and the District of Columbia have experienced an increase in 
their noncurrent loans over the last year [see Figure 7]. Particularly 
vulnerable to a downturn are banks in manufacturing areas that are 
highly dependent on energy production and distribution systems. Areas 
that rely heavily on manufacturing are experiencing falling earnings 
and slowing or negative employment trends.
    We expect credit quality to be an issue for banks throughout 2001, 
as the financial positions of some businesses and households weaken due 
to slow economic growth. This deterioration in credit quality will be 
an added drag on bank earnings.

Liquidity Risks
    Funding (or liquidity) risk at banks is also increasing as 
households and small businesses reduce their holdings of commercial 
bank deposits. Banks have traditionally relied on consumers and small 
businesses in their communities as a major source of funding. These so-
called core deposits, most of which are covered by Federal deposit 
insurance, have provided a stable and generally nonrate sensitive 
source of funding. With the rapid run up in the stock market in the 
1990's, however, and the widespread popularity of money market mutual 
funds, households and small businesses have increasingly shifted their 
savings and transaction accounts into pension funds, equities, and 
mutual funds. Deposits in banks and thrifts accounted for 10.5 percent 
of household financial assets in 2000, down substantially from 19 
percent in 1990 and 22 percent in 1980.
    Between 1993 and 2000, while annual asset growth in the banking 
system averaged 7 percent, core deposits at banks grew at a rate of 
less than 4 percent per year. This lagging growth in core deposits 
relative to asset growth is likely to continue.
    In response to the long-run, secular trend of slower deposit 
growth, banks have turned increasingly to higher interest rate 
wholesale funding. Both large and small banks have increased their 
reliance on wholesale (noncore deposit) funding sources to finance 
their incremental loan and asset growth. While large banks are 
accustomed to accessing the capital markets for funding, this is a new 
activity for many smaller banks. Because of costs and information 
constraints, small banks find it more difficult than large banks to 
raise funds through public debt offerings, securitizations, and other 
capital market instruments. Thus, we see that small banks are 
increasingly relying on wholesale providers such as the Federal Home 
Loan Banks as well as deposits obtained through the Internet or CD 
listing services. Although these sources can provide community banks 
with cost-effective funding, their use requires banks to have more 
rigorous management systems to monitor and control funding 
concentrations and maturity concentrations.
    Consequently, traditional measures of bank liquidity, such as the 
ratio of core deposits to assets, reflect increased liquidity risk for 
both small and large banks. For example, core deposits as a percentage 
of assets for small banks (those with less than $1 billion in assets) 
declined from 79.8 percent in 1992, the first year of recovery from the 
last recession, to 69.6 percent in 2000. For the larger banks, the core 
deposits to assets ratio declined from 56.6 percent in 1992 to 43.9 
percent in 2000.
    How a bank funds itself is important because when a bank 
experiences deteriorating credit quality, it faces the risk of pressure 
on its funding and liquidity. Wholesale funds are far more risk- and 
price-sensitive than federally insured core deposits. Prudent 
management of this type of funding, therefore, is increasingly 
important. In particular, community banks that engage in business 
lending and have high levels of wholesale funding need to have 
effective internal controls and realistic contingency funding plans.

OCC's Approach to Growing Risk in the Banking System
    A dynamic and healthy banking system is vital to the functioning of 
the overall economy. Our job as bank supervisors is to maintain a sound 
banking system by encouraging banks to address problems early so that 
they can better weather economic downturns and are in a position to 
contribute to economic recovery. As we have seen in the past, banks 
whose financial condition is seriously weakened by credit quality 
problems are less capable of extending credit because their attention 
is necessarily devoted to problem resolution and capital preservation.
    By acting early, in a measured and intelligent way, bank 
supervisors can moderate the severity of problems in the banking system 
that will inevitably arise when the economy weakens. By responding when 
we first detect weak banking practices, supervisors can avoid the need 
to take more stringent actions during times of economic weakness. 
Supervisors are most effective when they take early and carefully 
calibrated steps that target potential industry excesses and failures 
in risk-management. This approach will help us maintain a healthy 
banking system that can continue to extend needed credit to sound 
borrowers during difficult economic times.
    Since 1997, the OCC has implemented a series of increasingly firm 
regulatory responses to rising credit risk and weak lending and risk-
management practices. These efforts, which started with industry 
reminders and advisories about the dangers of weakening lending 
standards and poor credit risk-management, grew into more focused 
examination and policy responses as risks increased.

 In 1997, in response to a sharp increase in the incidence of 
    weakening underwriting standards reported by our examiners, we 
    required examiners to discuss the results of the 1997 Survey of 
    Credit Underwriting Practices with their banks' CEO's. We also 
    instructed examiners to discuss any examples of weak underwriting 
    disclosed in examinations directly with the bank CEO.
 In 1998, in response to further weakening of bank underwriting 
    and risk selection standards, we implemented the Loans With 
    Structural Weaknesses initiative to ensure that poorly underwritten 
    and other higher risk credits were brought directly to the 
    attention of bank management and boards. We instructed our 
    examiners to identify such loans in all reports of examination, to 
    criticize and classify such loans where appropriate, and to 
    incorporate the amount and severity of weaknesses found into their 
    conclusions about credit quality and portfolio management, and the 
    overall condition of the bank. Simultaneously, we formed a team of 
    our best credit experts to review loans from across the population 
    of our largest banks to identify examples of the types of 
    weaknesses our examiners were reporting. Based on this review, 
    which came to be called the Ugly Loan Project, we developed and 
    delivered a focused training program. The goals of that program 
    were to advance the credit risk evaluation and classification 
    skills of our examiners and to clarify our expectations about how 
    structural and other credit weaknesses should be incorporated into 
    their judgments about credit risk in individual loans and 
    portfolios. We issued a comprehensive guidebook and examination 
    procedures on Loan Portfolio Management to bankers and examiners to 
    clearly communicate our expectations for sound portfolio credit 
    risk-management processes. This guidance covers underwriting, loan 
    review and approval, exception reporting pricing and portfolio 
    stress testing.
 In 1999, we issued an industry advisory about the growing 
    risks associated with higher-risk leveraged and enterprise value-
    dependent credits. We initiated an effort to improve the 
    consistency of credit classifications among the banking agencies, 
    and led the development and issuance of interagency policies on 
    higher risk subprime and high loan-to-value lending activities.
 In 2000, we continued training efforts designed to sharpen our 
    examiners' risk recognition and credit classification skills, and 
    led the development of Interagency Risk Management Standards for 
    Leveraged Loans. This guidance, issued in 2001, establishes 
    consistent criteria among the agencies for evaluating and 
    classifying troubled leveraged and enterprise value dependent 
    loans. We also led the development of Interagency Guidance on 
    Accounting for Loans Held for Sale, which was issued this year, to 
    improve public disclosures of credit losses being taken by banks 
    that are selling problem and other loans in the secondary markets.

    Throughout this process we have maintained an open and candid 
dialogue with the banking industry and our examiners about rising 
credit risk in the system and the need for improved risk-management by 
bankers. Through regular meetings with individual bank CEO's and 
periodic meetings with groups of CEO's and Chief Credit Officers, we 
have discussed the risks involved with some of the weaker credit-
granting practices that seeped back into the system during the mid-to-
late 1990's. We have worked with bankers to identify and mitigate their 
higher risk, more vulnerable credits at a time when their capital 
accounts and income statements are most capable of absorbing the risk. 
We have also insisted on accurate risk identification and disclosure so 
market forces are capable of affecting change where appropriate.
    National banks have responded positively to these initiatives. 
Bankers are adjusting both their risk selection and underwriting 
practices. Credit spreads are wider, recent credit transactions are 
better underwritten than they were as little as 12 months ago, and 
speculative grade and highly leveraged financing activity has slowed in 
both the bank and public credit markets.
    The widening of credit spreads and tightening of risk selection and 
underwriting standards reflect a reassessment of risk tolerance by all 
credit providers, not just banks. Bankers are working diligently to 
shore up previously weak risk selection and underwriting practices, 
improve deficiencies in credit risk identification and risk-management, 
and strengthen reserves as appropriate. Our recent examining activities 
are confirming these positive responses.
    We recognize that we need to ensure a balanced approach as economic 
and credit conditions weaken. We have implemented, and will continue to 
follow, a careful but firm approach to addressing weak credit practices 
and conditions. In this regard, we are constantly mindful that the 
alternative approach of silent forbearance can allow problems to fester 
and deepen to the point where sound remedial action is no longer 
possible--a lesson that all bank supervisors learned painfully in the 
late 1980's and early 1990's.
    The OCC has also taken a number of steps to address our concerns 
about increasing liquidity and funding risk.

 Over the past 2 years, we have provided OCC examiners with 
    specialized liquidity risk-management training. That training 
    focuses on current funding trends and issues and the importance of 
    appropriate liquidity management, including bank contingency 
    funding planning.
 In February, we issued a Liquidity Handbook, which outlines 
    the OCC's expectations with respect to bank's liquidity risk-
    management practices. It highlights a number of elements necessary 
    for successful liquidity management, including a consolidated 
    liquidity strategy, effective risk-management tools, strong 
    internal controls, sound contingency funding plans, and reliable 
    management information systems.
 We have held a number of outreach activities and training 
    programs. Included among them was a telephone seminar, The 
    Challenges of Sound Liquidity Risk Management. OCC's Expectations 
    and Policy for Community Banks, held on May 15 and 16, 2001. The 
    seminar focused specifically on key aspects of managing community 
    bank liquidity. Staff from over 300 community banks participated in 
    the seminar.
 The OCC authored a Joint Advisory on Brokered and Rate-
    Sensitive Deposits, which the bank and thrift regulatory agencies 
    published in May of this year. The Advisory highlights for banks 
    the risk-management challenges posed by interest rate and credit-
    sensitive sources of funds.

    The growing complexity of the banking industry requires us to 
develop new and modern tools to help detect emerging weaknesses more 
quickly. The OCC has been strengthening our early warning systems, 
which now include a set of tools--we call it ``Project Canary''--
designed to enhance our identification of and supervisory responses to 
banks that may be more vulnerable to emerging risks. We have created 
financial measures based on Call Report data, and we look at changes in 
those measures in assessing movement to higher risk position levels, 
particularly in the area of credit, interest rate, and liquidity risks. 
For each measure, we have established benchmarks to assist in the 
identification of those banks with the highest 
financial risk positions. While risk taking is necessary in the normal 
course of banking, the paramount issue is whether high levels of risk 
taking are balanced with commensurate levels of risk-management. Bank 
managers, bank directors, and OCC examiners can use this information to 
look for high levels of risk and determine if risk-management and 
mitigants are appropriate for the given level of risk.
    Our early warning system also provides assessments of a bank's 
vulnerability to changes in economic conditions. We have developed 
several internal models, which we combine with existing external 
models, to better define those banks that may be at higher risk of 
adverse macroeconomic or regional economic developments. For example, 
we can review the potential earnings impact of layoffs in a particular 
industry or community for banks in that area.
    This early warning system is providing us with information to 
better calibrate our supervisory efforts and target the application of 
examination resources to the area of highest potential risk. Our 
supervisory managers use this information in planning examinations, 
allocating resources, and targeting key risks. These early warning 
tools also provide a useful, consistent method for identifying 
potential risk areas and performing comparative analysis. As such, they 
enable examiners and managers to better allocate resources through more 
focused examinations and offsite reviews. Supervisory offices use these 
measures as an oversight tool, by comparing the early warning reports 
to current risk assessments and supervisory plans, so that 
inconsistencies can be identified and resolved. And these tools also 
help us in assessing and tracking systemic risk.

Conclusion
    In conclusion, we believe the condition of the banking industry 
today is strong. The vast majority of banks have strong capital and 
earnings, improved risk-management processes, and more diversified 
revenue streams. As a result, we believe the banking industry today is 
better able to withstand adverse economic developments than it was 
going into the recession of the early 1990's.
    We are, however, in a period of heightened uncertainty concerning 
the domestic and global economic outlook. Credit problems are rising in 
our banks and we project continued pressure on bank earnings, at least 
over the near term. If the U.S. slowdown becomes deeper and persists, 
the effects on the banking industry will be much more serious. 
Declining earnings would heighten concerns about the safety and 
soundness of certain banks.
    As supervisors, we have the important responsibility to neither 
discourage nor encourage lending but to ensure the soundness of the 
banking system. In good times, this is easy. It is more difficult to do 
when economic conditions are deteriorating and we are challenged to 
ensure that our standards for safety and soundness are neither too 
harsh nor too lax. We have experience with the difficult long-term 
problems created when bank supervisors failed to act in a timely and 
measured fashion and they tried to play catch up after the damage is 
done.
    If we have learned anything from past economic crises both in the 
United States and overseas, we know that a sound banking system is 
essential to continued economic growth. I can assure you that the OCC 
will remain vigilant in our efforts to continually improve the risk-
management of national banks and thereby maintain a viable, healthy 
industry to support our economy.













                   PREPARED STATEMENT OF DONNA TANOUE

              Chair, Federal Deposit Insurance Corporation
                             June 20, 2001

    Mr. Chairman, Senator Gramm, and Members of the Committee, thank 
you for the opportunity to testify on behalf of the Federal Deposit 
Insurance Corporation (FDIC) regarding the condition of the bank and 
thrift industries and the deposit insurance funds.
    I am pleased to report that the banking and thrift industries 
continue to exhibit strong financial results. However, we are seeing 
signs of stress that indicate that this continued strong performance 
will be more difficult to maintain in the future. I will highlight 
three of these warning signs in my testimony today--subprime lending, 
vulnerabilities in the agricultural sector, and funding and liquidity 
challenges.
    Perhaps the most important message that I will leave with you today 
is that there are flaws in the current deposit insurance system and the 
best time for constructive debate on changes to deposit insurance is 
now, during a period of financial health for the banking and thrift 
industries, rather than in the charged atmosphere of a crisis. Today, 
depository institutions are strong and profitable. The deposit 
insurance funds also are in good financial condition and the FDIC 
stands fully prepared to fulfill its commitment to depositors. We 
should not, however, assume that these good times will last another 
decade. As you know, depositors in all walks of life have come to rely 
on FDIC insurance to guarantee that their insured deposits are 
absolutely safe. The financial strength of the FDIC and its ability and 
commitment to honor its responsibility to depositors are beyond 
question. Therefore, I urge this Committee to take advantage of this 
timely juncture and to move forward on reform to ensure that the 
strength and stability of our deposit insurance system remains 
unquestioned.

Condition of the Industry
    The banking sector continues to experience strong financial 
performance. Commercial banks recently completed their eighth 
consecutive year with an industry return on assets above 1 percent. A 
return on assets (ROA) of 1 percent or higher has traditionally been a 
benchmark of superior earnings performance. Prior to 1993, the 
commercial banking industry never had an annual ROA as high as 1 
percent. Almost 60 percent of all insured commercial banks reported an 
ROA of 1 percent or higher last year.
    Three main sources of strength drove bank earnings during this 
period of prosperity. First, the improvement in asset quality following 
the last recession has meant that expenses for credit losses have been 
less of a drain on banks' revenues. Second, noninterest revenues have 
been growing rapidly, as the industry has diversified its sources of 
income. Third, banks have had strong growth in assets, particularly in 
loans, as they have provided necessary credit to a record-breaking 
economic expansion.
    Many indicators of trouble--unprofitable banks, ``problem'' banks, 
undercapitalized banks, bank failures--all remain near their cyclical 
lows. Banks' capital has kept pace with the industry's growth. Today, 
more than 95 percent of all banks are in the highest regulatory capital 
group. The number of ``problem'' banks--78 banks, with $17 billion in 
assets at the end of last quarter--is near its cyclical low point.
    Our most recent earnings data, which we released earlier this 
month, show that net income of commercial banks set a new record in the 
first quarter of 2001. However, this record was made possible by 
nonrecurring gains on sales of securities. The industry's net operating 
income, which more closely reflects the strength of banks' ongoing core 
business, was $565 million below the level of a year earlier.
    Sustaining these very high levels of profitability has become 
increasingly difficult for the banking industry. There is evidence that 
many banks have taken on more risk as they have sought to maintain 
profitability. At the same time, some of the most important factors 
that have contributed to the industry's relative prosperity are 
becoming less favorable.
    Net interest margins--the difference between what banks earn on 
their loans and other investments and what they pay for deposits and 
other liabilities--reached a 14 year low in the first quarter. The 
margin decline stemmed from increased competition, which has put 
downward pressure on loan pricing and upward pressure on funding costs, 
and a relatively flat yield curve.
    The volume of problem loans has been growing for almost 2 years, 
mostly in loans to commercial and industrial (C&I) borrowers at large 
banks. Only one-third of all banks are showing deterioration in their 
C&I portfolios, but together they account for more than two-thirds of 
all C&I loans held by commercial banks. Moreover, most of the 
deterioration is centered in larger banks, particularly those with 
large and middle market corporate loan portfolios. This deterioration 
is reflected in the interagency Shared National Credit review program, 
which has reported two straight years of significant increases--albeit 
from a very low base--in classified and criticized credit volumes, a 53 
percent increase in 1999 and another 44 percent increase in 2000. The 
2001 Shared National Credit review is currently in progress and results 
will be available later this year, but indications are of a continuing 
trend.
    Credit card loans, which the FDIC identified as a potential concern 
in our 1997 testimony on industry condition, have shown an improved 
trend in loan losses since 1998. Up until the first quarter of this 
year, this improvement has paralleled an improving trend in personal 
bankruptcy filings through the end of 2000. However, personal 
bankruptcies in the first quarter of this year were up 18 percent over 
the previous year, raising the possibility of higher write-offs of 
credit card loans later this year.
    As the percentage of troubled loans has risen from cyclical lows, 
banks have had to apply an increasing share of their revenues to 
provisioning for loan losses. Last year, loss provisions absorbed 8.2 
percent of banks' net operating revenues, the highest proportion since 
1992. In the first quarter of this year, loss provisions were 36.1 
percent higher than a year ago.
    Concentrations of traditionally higher risk loans as a percent of 
capital also have been on the rise. The forthcoming issue of the FDIC 
Regional Outlook, which we will release shortly, shows that the percent 
of insured institutions with moderately high concentrations--that is, 
commercial and construction loans totaling between 400 and 700 percent 
of capital--has increased by more than half since 1995. A greater 
percentage of insured institutions, 17.1 percent, has concentrations in 
this 400 to 700 percent range now than at any time since at least 1984. 
This fact is troubling as history shows that banks with concentrations 
such as these consistently tend to fail more often than banks with 
lower concentrations--as much as 2 to 3 times as often by some 
measures. It is important to recognize that the higher capital levels 
we see are accompanied in many cases by higher portfolio risks.
    The FDIC is addressing the increase in credit risk in several 
different ways. The FDIC employs a risk focused examination approach 
that enables examiners to prioritize risk and allocate staff to those 
areas of the bank that represent the most risk. Enhanced examination 
software tools give our examiners the ability to perform more 
sophisticated loan reviews with special emphasis on the higher risk C&I 
and construction/development loans. In addition, the FDIC recently 
instituted a large bank supervision program that provides more on-going 
supervision throughout the year for many of our largest institutions. 
Our offsite monitoring programs provide current data on loan growth and 
performance trends that are closely reviewed by staff assigned to 
monitor each insured bank. We also monitor the industry and local real 
estate markets through other vehicles such as the Report on 
Underwriting Practices and the Survey of Real Estate Trends. We 
continue to work closely with other regulators to improve the 
information exchanges and interagency cooperation that are necessary in 
today's rapidly evolving banking system. An example is the recently 
issued additional guidance to banks on risk-management practices for 
leveraged financing.
    As we contemplate further weakening in asset quality and slowing 
revenue growth in the near term, we should recognize that the banking 
industry today is far stronger than when it entered the last economic 
downturn more than 10 years ago. Banks now have more opportunities for 
geographic diversification and new sources of income. Banks also have 
been able to control growth in their overhead expenses, and to steadily 
improve efficiency.
    Many of the observations made about commercial banks apply to 
insured savings institutions as well. While the profitability of 
insured savings institutions has been somewhat lower than the 
profitability of commercial banks, the past few years have brought 
strong earnings and growth for the thrift industry as well. Reflecting 
their historical role as providers of financing for homeownership, more 
than two-thirds of all loans held by insured savings institutions are 
home mortgage loans. At commercial banks, home mortgages account for 
less than one quarter of all loans. The large share of home mortgages 
in their loan portfolios means that most thrifts have lower net 
interest margins and lower credit risk than commercial banks. However, 
thrifts are subject to the same competitive pressures, and exhibit many 
of the same trends in performance and condition that we see at 
commercial banks.

Condition of the Insurance Funds
    The two deposit insurance funds managed by the FDIC reflect the 
favorable condition of the bank and thrift industries. The Bank 
Insurance Fund (BIF) reported a balance of $31.4 billion (unaudited) as 
of March 31, 2001, compared to $31 billion at year-end 2000. One BIF-
member institution failed in the first quarter of 2001, and there have 
been just 22 BIF-member failures over the preceding 5 years. The BIF 
balance has grown in each of the last five quarters, but these 
increases failed to keep pace with strong growth in BIF insured 
deposits. As a result, the BIF reserve ratio \1\ has drifted downward, 
from 1.36 percent of estimated insured deposits at the end of 1999 to 
1.32 percent as of March 31, 2001. From March 2000 to March 2001, BIF 
insured deposits increased by $180 billion. Nearly one-third of this 
amount ($57 billion) can be attributed to two organizations that have 
been sweeping brokerage-originated cash management funds into insured-
deposit accounts at BIF-member bank affiliates. The insured deposit 
growth at these two organizations--without additional contributions to 
the insurance fund--has been enough to account for a 3 basis point 
decline in the BIF reserve ratio.
---------------------------------------------------------------------------
    \1\ The reserve ratio is the fund balance divided by the dollar 
volume of the estimated insured deposits.
---------------------------------------------------------------------------
    The Savings Association Insurance Fund (SAIF) also has reported 
steady growth, resulting in a balance of $11 billion as of March 31. No 
SAIF members have failed thus far in 2001, and only three SAIF members 
failed in the preceding 5 years. Recent insured deposit growth has been 
relatively strong for the SAIF, although less so than for the BIF. SAIF 
insured deposits grew 1.7 percent during the first quarter of 2001 and 
5.8 percent during 2000, compared to average annual growth of 0.6 
percent in the preceding 5 years. The SAIF reserve ratio stood at 1.43 
percent on March 31, which was unchanged from year-end 2000 and down 
slightly from 1.45 percent at the end of 1999. Brokerage account sweeps 
added an estimated $2 billion to SAIF insured deposits, accounting for 
a one-half basis point decline in the SAIF reserve ratio.

Challenges to Continued Strong Performance
    A transition from a decade of rapid economic growth to the slower 
growth the U.S. economy is now experiencing will, to some degree, 
adversely affect bank earnings. The impact is likely to be greatest on 
institutions that have been most aggressive in their selection of 
risks. In this regard, as they develop risk-management strategies, 
insured institutions need to allow for the potential for economic 
conditions to be less favorable than prevailed during the 1990's.
    Experience suggests that a weakening economy takes some time to 
affect banks. I would like to devote some attention to two issues that 
are more immediately before us, namely those posed by subprime lenders 
and lenders dependent on the agricultural economy. I also will discuss 
an issue that is extremely important to many banks today, that of 
funding and liquidity.

Subprime Lending
    The FDIC continues to have concerns regarding subprime consumer and 
mortgage lending. We are closely watching approximately 150 
institutions that have subprime lending programs, for example, programs 
that purposely target subprime markets, in volumes that equal or exceed 
25 percent of capital.
    Subprime lending can be--and indeed, has been--beneficial to 
borrowers with blemished or limited credit histories and is an 
acceptable activity for insured institutions, provided that the 
institution has proper safeguards in place. Without these safeguards, 
mistakes can be costly, as evidenced by the role subprime lending has 
played in recent failures. Subprime lending figured prominently in 6 of 
the 20 bank and thrift failures in the past 3\1/2\ years. Further, 
since most subprime lenders in the bank and thrift industry have not 
been tested in an economic downturn, it is realistic to expect 
additional problems for institutions with concentrations of subprime 
loans should economic conditions deteriorate further.
    Several factors that are very often associated with subprime 
lending can create problems for the lenders, their regulators, and for 
the FDIC as receiver for failed institutions. One factor is the nature 
of the assets created as a by-product of loan securitization. In a 
securitization, the subprime lender sells packages of loans to another 
party or institution, but often retains the right to receive a portion 
of the cashflows expected from the loans. The expected value of these 
cashflows is generally referred to as the retained interest, or 
residual.
    The residual holder's right to receive cashflows is generally a 
deeply subordinated position relative to the rights of the other 
security holders (as such, they serve as a credit enhancement to the 
other securities). To determine the value of this residual, the tender 
must make a variety of assumptions about the underlying loans, which 
would include delinquency rates, charge-off rates, and discount rates. 
As a result, and particularly with subprime loans, the accurate 
valuation of the residuals can be extremely difficult, making the 
residuals a highly illiquid and very volatile asset. In institutions 
with excessive concentrations of residuals, the safety and soundness of 
a bank or thrift may be threatened if the valuations turn out to be 
overly optimistic.
    The complexity of subprime loan securitizations also means that 
accounting deficiencies are more likely. In some of the failures 
involving subprime lenders that securitized loans, accounting 
statements were deemed inadequate or inappropriate by bank supervisors.
    Finally, subprime lending programs may use third parties for loan 
origination, servicing or other activities. The use of third-party 
originators and servicers is a standard business practice that can 
reduce bank costs and enhance efficiency. However, poor analysis and 
monitoring of loans purchased from third parties have contributed to 
the failure or near-failure of a few institutions due to 
misrepresentation, and even apparent fraud, on the part of the 
originator.
    We have intensified our supervisory attention to the roughly 150 
banks and thrifts with subprime lending programs. The banking agencies 
released the March 1999 Interagency Guidance on Subprime Lending. In 
January 2001, the agencies distributed the Expanded Guidance for 
Subprime Lending Programs. The focus of our supervisory attention is on 
the need for more intensified risk-management procedures and internal 
controls for such higher risk lending programs, as well as the need for 
appropriate levels of reserves and capital.

Vulnerabilities in the Agriculture Sector
    Farm banks remain in a vulnerable position as their profitability 
is linked so strongly to the uncertain economics of farming and the 
continuance of Government support payments. Without Government 
payments, many farmers would have significantly more difficulty meeting 
loan payments.
    Today, more than 1,900 banks hold more than 25 percent of their 
loans in farm loans. While these farm banks constitute some 23 percent 
of all commercial banks, these banks tend to be smaller, rural 
community institutions, and hold less than 2 percent of all bank 
assets. Farm banks are highly sensitive to local economic conditions, 
being less diversified in their lending and sources of income. For 
instance, noninterest income contributes less than 15 percent of farm 
banks' revenue compared to over 43 percent for other commercial banks.
    The FDIC is not predicting serious near-term problems in the farm 
bank sector. In spite of the well-publicized stress in the agriculture 
sector, the performance of farm banks, on average, remains quite steady 
with loan quality and capital positions remaining relatively strong. 
Only 2 percent of farm banks lost money in 2000. Most farm banks are 
currently well capitalized and well managed and generally are in much 
better financial condition than they were before the 1980's farm 
crisis.
    Over the longer term, farm banks face the difficult issue of rural 
depopulation. U.S. Census data indicate that the Midwest has most of 
the counties in the United States that have lost population since 1970. 
Farms have been consolidating for decades, resulting in larger farms 
and lower populated rural areas.
    To date, two sources of income have helped farmers, and thereby 
farm banks, avert a more serious financial crisis. In aggregate, farm 
households have come to depend more on off-farm income, mostly wages 
and salaries, for their livelihood. In addition, Federal assistance 
remains significant, providing 49 cents of every dollar farmers earned 
in 2000.
    However, the FDIC must remain vigilant for further declines in the 
agricultural economy. The U.S. Department of Agriculture currently 
forecasts a decline in net cash farm income in 2001 to under $51 
billion, down from $56.4 billion last year (assuming no supplemental 
assistance for the 2001 crops). Higher energy costs also play a role in 
the forecasted decline.

Funding and Liquidity
    During this record economic expansion, loan growth in the 
commercial banking industry has been exceptionally strong while deposit 
growth has failed to keep pace. This raises questions of decreased 
liquidity and continued credit availability, especially at community 
banks.
    Since 1992, loans held on bank balance sheets have increased by 
$1.8 trillion or at an 8.3 percent compounded growth rate. In contrast, 
core deposits grew by only $709 billion, which translates to a 3.6 
percent compounded growth rate. As a result, the share of commercial 
banks' assets funded by core deposits has declined steadily from its 
peak level of 62 percent at year-end 1992, to 46 percent at the end of 
2000. During that same period, the percent of banks' assets that 
consists of loans increased from 56 percent to 60 percent.
    Pressures stemming from the need to fund rapid loan growth are 
particularly evident at community banks, which traditionally have 
relied almost exclusively on core deposits to fund balance sheet 
growth. In this environment of strong loan demand, the balance sheets 
of banks with less than $1 billion in assets have undergone shifts in 
the composition of their assets and liabilities that have increased 
many community banks' exposure to interest rate risk, credit risk, and 
liquidity risk.
    Many small banks appear to be liquidating securities to fund loan 
growth, and increasing the proportion of higher yielding, higher-risk 
loans in their portfolios in order to offset the increased cost of 
funding. This has helped to limit the erosion in community bank 
profitability in recent years. But these changes have left many small 
banks more vulnerable to rising interest rates and a slowing economy.
    The ongoing loss of liquidity in banks' balance sheets is evidenced 
by the industry's historically high and rising loans-to-assets ratio. 
Loans are less liquid, that is, they are harder to convert into cash 
than assets such as U.S. Treasury securities or other marketable 
securities. Similarly, core deposits are important because they are not 
as volatile as many alternative sources of funds. They do not reprice 
quickly when interest rates rise, and because they tend to be fully 
insured, they do not flow out of banks when concerns about an 
institution's health arise. The loss of liquidity is also shown by the 
declining ratio of core deposits to assets, as banks have increased the 
share of loans in their asset portfolios and funded a growing share of 
their assets with nondeposit liabilities.
    Increased reliance on liabilities other than core deposits implies 
potentially higher and more volatile funding costs for banks. Banks' 
inability to fund asset growth exclusively with core deposits has led 
to a growing dependence on large certificates of deposit and Federal 
Home Loan Bank (FHLB) advances. At the end of 1992, only 4.6 percent of 
commercial banks had any FHLB borrowings; these advances provided only 
0.2 percent of commercial banks' funding. By the first quarter of this 
year, 45 percent of commercial banks had FHLB advances, which supplied 
2.9 percent of the industry's funding.
    There is no question that FHLB advances and other nondeposit 
funding sources play an important role in depository institutions' 
liquidity and funds management strategies. New Call Report data showed 
that, at the end of March, 52 percent of banks' FHLB advances had 
maturities in excess of 3 years. This suggests that many banks are 
attempting to use these advances to hedge interest-rate exposures of 
their longer-term assets. However, FDIC examiners have raised 
supervisory concerns in certain cases when a large concentration of an 
institution's funding needs were being met by FHLB advances or other 
wholesale funds and management did not fully understand the risks 
associated with those funding sources. Late last year, the FDIC issued 
guidance to our examiners for reviewing FHLB advances. Finally, on May 
11, 2001, the FDIC and the other Federal bank and thrift regulatory 
agencies issued a joint advisory on the risks of brokered and other 
rate-sensitive deposits that outlined prudent risk identification and 
management practices for deposits.
    There is some evidence that liquidity pressures are easing. The 
past two quarters have seen a pickup in growth in core deposits, led by 
increases in money market deposit accounts. These savings accounts, 
which offer access to funds while paying interest on balances, can 
represent ``safe havens'' for investors seeking risk-free, short-term 
investments. Growth in banks' domestic deposits has surpassed growth in 
loans for two consecutive quarters. But, two quarters is not a trend, 
and it is much too early to determine if recent strong deposit growth 
is credible.

Deposit Insurance Reform
    Last year, the FDIC initiated a comprehensive review of the deposit 
insurance system. Our review identified some important flaws in the 
system, which we described in an Options Paper issued last August. I 
will describe the flaws and our recommendations for fixing them. A 
consensus appears to be emerging in support of several of the FDIC's 
recommendations, but some important implementation issues remain. I 
urge the Committee to take up these issues with my successor as soon as 
practicable, to ensure that we take advantage of the opportunity to 
enhance the deposit insurance system in good times, when the industry 
is strong.

The Case for Reform
    One of the key flaws in today's system is that deposit insurance 
premiums do not reflect the risk that individual institutions pose to 
the system. Although the FDIC Improvement Act (FDICIA) mandates a risk-
based deposit insurance premium system, other provisions of law 
prohibit the FDIC from charging premiums to institutions that are both 
well capitalized, as defined by regulation, and well managed (generally 
those with the two best examination ratings) when a fund's reserve 
ratio is at or above the Designated Reserve Ratio (DRR) of 1.25 
percent. As a result, over 92 percent of insured institutions are in 
the FDIC's best-risk category and currently pay no deposit insurance 
assessment. All institutions pose some risk, and there are significant 
and identifiable differences in risk exposure among the institutions in 
the best-rated premium category. Indeed, even institutions with 
different CAMELS ratings (CAMELS ``1'' or ``2'') pay the same amount 
for insurance--zero. Having institutions with different risk 
characteristics all paying nothing for insurance renders the risk-based 
premium system ineffective, reduces the incentive for banks to avoid 
risk and forces safer institutions to subsidize riskier institutions.
    The inability to price risk appropriately has had a number of other 
negative effects. Since very little in premiums has been collected 
since 1996, the deposit insurance system is financed almost entirely by 
those institutions that paid premiums in the past. There are currently 
over 900 newly chartered institutions, with over $60 billion in insured 
deposits, that have never paid premiums.
    In addition, deposit insurance that is underpriced creates an 
incentive for institutions to grow rapidly. Financial institutions 
outside the realm of traditional banking recently began to make greater 
use of FDIC insured deposits in their product mix. Large dollar volumes 
of investment firm brokerage accounts were swept into deposit accounts 
in their FDIC insured subsidiaries. To the extent that these 
institutions are in the best-rated premium category, they pay no 
insurance premiums for this rapid growth. Since they are not paying for 
insurance, new institutions and fast-growing institutions are 
benefiting at the expense of their older competitors and slower-growing 
competitors. Rapid deposit growth lowers a fund's reserve ratio and 
increases the probability that additional failures will push a fund's 
reserve ratio below the DRR, resulting in a rapid increase in premiums 
for all institutions.
    The second flaw in the current deposit insurance system identified 
by the FDIC study is that premiums are volatile and are likely to rise 
substantially during an economic downturn when financial institutions 
can least afford to pay higher premiums. By law, when a deposit 
insurance fund's reserve ratio falls below the DRR, the FDIC must raise 
premiums by an amount sufficient to bring the reserve ratio back to the 
DRR within 1 year, or charge all institutions at least 23 basis points 
until the reserve ratio meets the DRR. However, during a period of 
heightened insurance losses, both the economy and depository 
institutions in general are more likely to be distressed. A 23 basis 
point premium at such a point in the business cycle would be a 
significant drain on the net income of depository institutions, thereby 
impeding credit availability and economic recovery.
    In addition to these two key flaws in the deposit insurance system, 
our review addressed two other important issues. The first is the 
existence of two separate deposit insurance funds. As long as the FDIC 
maintains two funds, whose assessment rates are determined 
independently, the prospect of a premium differential with its 
attendant inefficiencies and inequities exists. Separate funds also are 
not as strong as a combined deposit insurance fund would be. Moreover, 
because each insurance fund now insures both banks and thrifts, there 
is little justification for maintaining separate funds.
    The second issue is the erosion in the real value of deposit 
insurance over time. Deposit insurance coverage is an important 
component of the Federal Government's program to promote financial 
stability, yet there is no mechanism for regular adjustments to 
maintain its real value as the price level rises.

The FDIC's Recommendations
    The FDIC published the following recommendations for reforming our 
deposit insurance system on April 5, 2001.

 The current statutory restrictions on the FDIC's ability to 
    charge risk-based premiums to all institutions should be 
    eliminated; the FDIC should charge premiums on the basis of risk, 
    independent of the level of the fund.
 Sharp premium swings triggered by deviations from the 
    designated reserve ratio should be eliminated. If the fund falls 
    below a target level, premiums should increase gradually. If the 
    fund grows above a target level, funds should be rebated gradually.
 Rebates should be determined on the basis of past 
    contributions to the fund, not on the current assessment base.
 The Bank Insurance Fund and the Savings Association Insurance 
    Fund should be merged.
 The deposit insurance coverage level should be indexed to 
    maintain its real value.

    Collectively, these recommendations will result in a deposit 
insurance system that will allocate the assessment burden more smoothly 
over time and more fairly across institutions. They are not designed to 
increase the long-term assessment revenue to the FDIC.
    These reforms are designed to be implemented as a package. Picking 
and choosing among the parts of the proposal without focusing on the 
interaction between the various recommendations could weaken the 
deposit insurance system, magnify macroeconomic instability, and 
distort economic incentives.
    At a general level, a consensus appears to be emerging in support 
of several of our conceptual recommendations. There is broadening 
agreement that:

 The deposit insurance system must be less procyclical. That 
    is, premiums should not rise sharply during an economic downturn 
    taking funds out of the banking system when they are needed most to 
    help fuel a recovery.
 The FDIC must be able to charge appropriately for risk, both 
    because the current system creates perverse incentives and because 
    riskier institutions should shoulder more of the assessment burden 
    for deposit insurance.
 Reform must address the issue of deposit growth, to lessen the 
    impact of rapid growers on the rest of the industry and to bring a 
    measure of fairness to the funding of the deposit insurance 
    program.

    Some important implementation issues remain to be resolved. These 
are the issues on which the FDIC will need to focus its discussions and 
build consensus going forward. One is how to set the target level for 
the fund. It is important to note, however, that a target level, be it 
a point or a range, should probably not be fixed permanently. It would 
be wise to revisit the performance of the fund and general economic 
conditions every few years and adjust accordingly. Another issue is how 
to differentiate among institutions on the basis of risk and charge 
premiums accordingly. A third issue is how to determine the size and 
allocation of rebates.
    The FDIC's reform proposals were accompanied by various 
illustrative examples of ways of addressing these issues. These issues 
require policymakers to weigh and balance important policy goals. For 
example, in determining how to price risk across banks, actuarial 
judgments must be balanced against public policy goals. On an actuarial 
basis, banks with substantial loan concentrations pose a greater risk 
to the insurance fund, other things being equal. From a public policy 
point of view, however, it may not be desirable to over-penalize 
lenders in communities that happen to be dependent upon particular 
industries. As the examples illustrate, none of these issues are 
insurmountable, and working together we can implement meaningful 
deposit insurance reform.

Conclusion
    I appreciate the opportunity to testify regarding the overall 
strength and prosperity of the banking industry. Today's strong economy 
and banking system also provide a window of opportunity to improve the 
deposit insurance system. It would be a missed opportunity to wait 
until the economy and the banking industry are suffering and the 
results of the weaknesses in the deposit insurance system have become 
all too evident. The FDIC's recommendations will strengthen the deposit 
insurance system, promote economic stability, enhance safety and 
soundness, and make the system more equitable.
    These reforms will work best if implemented as a package. In 
particular, the ability to price for risk is essential to an effective 
deposit insurance system. Picking and choosing among the parts of the 
proposal could weaken the deposit insurance system, magnify 
macroeconomic instability, and distort economic incentives. Trying to 
address other issues without addressing risk pricing does not solve one 
of the most fundamental flaws in the current system.
    I would like to thank Chairman Sarbanes, Senator Gramm, and Members 
of the Committee once again for the Committee's interest in this 
important issue and for the opportunity to present the FDIC's reform 
proposals. I hope that this Committee and the Congress, working with my 
successor, will be able to bring about these much needed reforms.
    In closing, I also would like to thank my colleagues at the FDIC 
who produced the reform recommendations I have discussed and who work 
so hard at insuring a safe and sound financial system for the American 
people. It has been a pleasure and a privilege to work with them.
                               ----------
                  PREPARED STATEMENT OF ELLEN SEIDMAN
Director, Office of Thrift Supervision, U.S. Department of the Treasury
                             June 20, 2001
I. Introduction
    Mr. Chairman, thank you for the opportunity to appear before the 
Committee to discuss the financial condition and performance of the 
thrift industry. As the Director of OTS, I have come to appreciate how 
difficult it is to change perceptions. We often hear that perception is 
reality. Sometimes perception is reality, but not always. The thrift 
industry is a case in point. Today, many of those who do not follow the 
industry closely still perceive the industry as being deeply troubled. 
The memory of the thrift crisis lingers in the Nation's collective 
consciousness. In 1988, one in five thrifts was insolvent. Equity-to-
assets ratios averaged 3.5 percent. In that year alone the industry 
reported losses of $13.3 billion.
    Working together, President Bush and Congress passed the Financial 
Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) to 
address the 
crisis, and clean-up problem thrifts. By 1991, the thrift industry had 
returned to profitability and began a long process of restoration, 
stabilization, and strengthening.

Where Is the Industry Today?
    Today's thrift industry is strong and growing. Profitability, asset 
quality, and other key measures of financial health are at or near 
record levels. The average equity-to-assets ratio is over 8 percent, 
and 98 percent of thrifts are well capitalized. Problem thrifts and 
loan loss rates are very low. Mortgage loan originations are at or near 
record levels. And only three thrifts have failed in the past 5 years.
    Many factors are responsible for the current health of the thrift 
industry. Obviously, the Nation's long-running economic prosperity and 
the quality of thrift management are two critical factors. We must also 
recognize the contribution of critical statutory and regulatory reforms 
that have been initiated over the last twelve years to strengthen the 
banking system. The reforms of FIRREA, and the Federal Deposit 
Insurance Corporation Improvement Act of 1991 (FDICIA), which mandated 
new capital standards, uniform standards for lending, operations and 
asset growth, and prompt corrective action, played a large role in 
strengthening the system. New supervisory tools and enforcement powers, 
such as the Examination Parity and Year 2000 Readiness for Financial 
Institutions Act, have given us the ability to intercede more quickly 
and forcefully if problems develop at an institution. At OTS we have 
worked hard, through recruiting, training, our new accreditation and 
professional development programs, and other new supervisory tools, to 
make certain our staff is equipped to deal with the challenges of an 
ever more complex industry.

II. Condition of the Thrift Industry
    As of March 31, 2001, there were 1,059 OTS-regulated thrifts, 
holding assets of $953 billion. Though consolidation continues to 
reduce the number of thrifts, asset growth has been strong, and assets 
are at the highest level since March 1991.
    While there are some large thrifts that operate nationwide, most 
thrifts are small, community-based financial service providers. As of 
the first quarter of 2001, 71 percent of thrifts had assets less than 
$250 million. Mutual thrifts comprise 39 percent of the industry, but 
have only about 7 percent of the industry's assets. The industry 
employs 182,000 people, maintains over 61 million insured deposit 
accounts, and holds over $668 billion in housing related-loans and 
securities, including $458 billion in whole single-family loans, 
representing over 48 percent of thrift assets.

A. Earnings and Profitability
    In recent years, the earnings and profitability of the thrift 
industry have been strong--a trend that continued into the first 
quarter of this year. First quarter earnings were $2.16 billion--the 
third best quarterly earnings on record. For the year 2000, the 
industry reported earnings of $8.0 billion, just shy of the record 
earnings of $8.2 billion posted in 1999.
    The industry's return on average assets, a key measure of 
profitability, was a healthy 0.92 percent in the first quarter of this 
year and 0.91 percent in the year 2000. The industry posted yearly 
returns on assets above 0.90 percent for the last 3 years--a feat last 
achieved in the late 1950's.
    In large part, the strength and stability of the industry's 
earnings can be attributed to diversification of income sources, and 
strong asset quality.
    The industry's success over the past decade in expanding its line 
of products and services, such as mutual fund and annuity sales, trust 
activities, and transaction accounts, has enabled the industry to 
diversify its income stream and generate more stable earnings. Higher 
proportions of noninterest income helped stabilize thrift income and 
provided better insulation against interest rate fluctuations. 
Noninterest income as a percent of thrifts' gross income more than 
doubled over the past 10 years to 12.4 percent for 2000 from 5.1 
percent in 1990.
    Smaller thrifts, as a whole, did not fully participate in the 
overall industry earnings expansion. While remaining stable, smaller 
thrift earnings have lagged overall industry earnings for the last 3 
years. Part of the reason for smaller thrifts' lag in earnings is that 
they hold higher than average proportions of lower yielding assets--
cash, U.S. Treasury securities, and nonmortgage related investment 
securities. As of the first quarter, thrifts with assets under $100 
million held 16.8 percent of their total assets in lower yielding 
assets compared to the industry average of 7.4 percent. In addition, 
the majority (56 percent) of mutual thrifts had first quarter assets 
under $100 million. Mutual thrifts are not under shareholder pressure 
to maximize profits and pay dividends. However, mutual thrifts often 
``share'' profitability with their owners--depositors--through higher 
interest rates and lower fees on deposit accounts. Mutuals are also 
active participants in the economic development of their communities. 
This sharing of profitability lowers net earnings.

B. Asset Quality
    The overall quality of thrift asset portfolios is strong and key 
measures of problem loans are at or near historic lows. Troubled assets 
(loans 90 or more days past due, loans in nonaccrual status, and 
repossessed assets) were 0.62 percent of assets in the first quarter, 
slightly above the recent low of 0.58 percent at September 30, 2000. 
The ratio of troubled assets-to-total assets has remained below 1 
percent since September 1997.
    As might be expected in the current economic environment, the level 
of delinquent loans has been increasing. The industry's noncurrent loan 
ratio increased in the three most recent quarters, albeit from a record 
low level. However, less seriously delinquent loans--those 30-89 days 
past due--were 0.70 percent of assets in the first quarter, down from 
0.74 percent at the end of 2000.
    The majority of the overall increase in thrift noncurrent loans was 
due to arise in delinquent business-related loans, namely, commercial 
loans, nonresidential mortgages, and construction loans. Although the 
dollar amount of the typical business-related loan is larger than the 
typical consumer-related loan, the industry's total investment in 
business-related loans is small--less than 10 percent of all thrift 
assets. Thus, the overall increase in noncurrent loans reflects the 
delinquency of a small number of loans at a few thrifts.
    Loan charge-off rates have also remained at low levels. Net charge-
offs as a percent of total assets were 0.19 percent (annualized) in the 
first quarter, down slightly from 0.20 percent in 2000. The low charge-
off rates reflect the high quality of thrift loan portfolios, which are 
heavily concentrated in single-family mortgages. Charge-off rates for 
single-family mortgages are generally very low compared to other types 
of loans. The loan charge-off rate was 0.05 percent of all single-
family mortgages in the first quarter (annualized), or $50 per $100,000 
of loans.
    Thrifts' loan loss reserves have remained relatively constant at 
approximately 1 percent of total loans since 1999, reflecting the low 
levels of troubled assets and charge-off rates. The industry's reserve 
ratio is somewhat lower than that of the commercial banking industry. 
Again, this is due to thrifts' higher percentage of assets held in 
mortgage loans, which have lower loss rates than commercial loans.

C. Capital
    Capital measures for the industry are strong, stable, and well in 
excess of minimum requirements. Equity capital was 8.1 percent of 
assets in the first quarter, with 98 percent of the industry exceeding 
well-capitalized standards.\1\ Only four thrifts were less than 
adequately capitalized at the end of the first quarter, and each is 
operating under an OTS-approved capital restoration plan.
---------------------------------------------------------------------------
    \1\ On November 3, 2000, OTS and the other Federal banking agencies 
requested public comment on an advance notice of proposed rulemaking 
that considers establishment of a simplified regulatory capital 
framework for noncomplex institutions. And on September 27, 2000, OTS 
and the other Federal banking agencies requested public comment on 
proposed revisions to capital rules for residual interests in asset 
securitizations or other transfers of financial assets.
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D. Funding Sources
    While capital ratios remain strong, the industry has become 
somewhat more dependent on wholesale funding as deposit growth has 
slowed due to changing savings and investment patterns and the strong 
competition from mutual funds. Although deposits remain the primary 
source of funding for the industry, the ratio of total deposits-to-
total assets has declined steadily over the past decade. In 1990, 
deposits funded 77.0 percent of thrift assets. By the end of first 
quarter of 2001, the ratio had declined to 57.0 percent.
    Though the dollar volume of deposit growth has slowed, the number 
of deposits has increased since 1998, from 50.4 million in 1998, to 
61.2 million as of the first quarter of 2001. The average size of small 
denomination deposits (those under $100,000) was $6,900 as of the first 
quarter of 2001, compared to $8,000 in 1998, reflecting the industry's 
increase in noninterest bearing checking accounts that typically carry 
relatively small balances. Such deposits increased by 28 percent to 
$36.8 billion in the first quarter, from $28.7 billion at the end of 
1998.
    With deposits declining as a source of funding, the thrift industry 
has become more dependent on wholesale funding, primarily in the form 
of Federal Home Loan Bank (FHLB) advances. At the end of the first 
quarter, FHLB advances funded 22.8 percent of total thrift assets, up 
from 7.4 percent in 1991. In addition, other types of borrowings, such 
as repurchase agreements, subordinated debt, and Federal funds 
purchased, funded 8.9 percent of assets, up from 5.5 percent in 1991.

E. Interest Rate Risk
    Interest rate risk remains a key concern in the thrift industry. 
Interest rate risk is a natural by-product of the industry's basic 
business of making long-term mortgages, which are generally funded with 
shorter-term deposits and other borrowings.
    Interest rate risk was at the forefront of supervisory concern 
during 1999 and early 2000 as rising interest rates and a sharply 
inverted yield curve combined to put downward pressure on the 
industry's profit margins. Interest rate risk in the industry, however, 
has eased considerably since then. Interest rates have fallen 
dramatically and the yield curve has returned to a more normal shape. 
Thrift management also took steps to change their asset mix to reduce 
interest rate risk. Thrifts are now reporting wider net interest 
margins and generally lower levels of interest rate risk exposure.
    OTS, alone among the Federal bank regulators, has implemented a 
stress-test based supervisory strategy for evaluating the interest rate 
risk of the institutions we regulate. As a result, both we and the 
institutions are able to effectively assess and deal with any increase 
in interest rate risk sensitivity arising from changing interest rates 
or funding through noncore deposit sources, including FHLB advances 
with embedded options. As of the first quarter, 73 percent of all 
thrifts were classified as having low levels of interest rate risk, 18 
percent as having medium levels, and 9 percent as having higher levels. 
Those in the higher risk level category are given close supervisory 
scrutiny.\2\
---------------------------------------------------------------------------
    \2\ On April 12, 2001, the OTS issued a new Regulatory Handbook 
section on Derivative Instruments and Hedging that included an expanded 
discussion of risks of using derivatives, a discussion of OTS's policy 
on derivatives that incorporates sensitivity analysis or stress testing 
from TB13a, and a discussion of FASB's SFAS No. 133, Accounting for 
Derivative Instruments and Hedging Activities.
---------------------------------------------------------------------------
F. Problem Thrifts
    The number of problem thrifts--those with composite safety and 
soundness examination ratings of 4 or 5--remains low. There were 14 
problem thrifts at the end of the first quarter, up from 10 in 
September 1999--the lowest level since OTS's inception. Assets of 
problem thrifts have also remained low and stood at 0.5 percent of 
industry assets as of the first quarter. Thrifts categorized as being 
in ``problem status'' are subject to increasingly strong supervisory 
action to ensure that management and the board of directors move to 
resolve the institution's problems.
    Thrifts that are rated composite ``3'', while not considered 
problem institutions, warrant more than the normal level of supervisory 
attention. The number of institutions with 3 ratings rose from a recent 
low of 67 in 1998, to 98 by the end of 2000. (The commercial banking 
industry had a similar increase in 3-rated institutions during this 
period.) By the end of the first quarter, the number had declined to 
90. Of these, 91 percent were ``well-capitalized,'' and thus have a 
capital cushion that increases their ability to work through their 
difficulties in an orderly manner.\3\
---------------------------------------------------------------------------
    \3\ On April 30, 2001, the OTS proposed amendments to its 
assessment rule that would more accurately reflect the increased costs 
of supervising 3-, 4-, and 5-rated institutions.
---------------------------------------------------------------------------
    Supervisory attention is also focused on thrifts identified in 
other types of examinations, such as compliance, Community Reinvestment 
Act (CRA), and information technology (IT), as needing improvement. As 
of the first quarter, there were 67 thrifts rated 3 or below in 
compliance, including 6 thrifts rated 4 or 5. Sixteen thrifts were 
rated less than satisfactory in their CRA examination. Reflecting the 
rapid changes in technology, focus on privacy and security concerns, 
and increased demand for technologically savvy managers, 35 thrifts 
were rated 4 or 5 on their IT exam, and 24 were rated 3. In all cases, 
we work with these institutions to help them return to strong ratings.

G. Continuing Role of the Thrift Industry

1. Community Lenders with Residential Focus
    Although thrifts can make consumer and, in limited quantities, 
commercial loans, they remain primarily focused on residential mortgage 
lending. Thrifts originated over 21 percent of all single-family 
mortgages made in the United States in the first quarter. Moreover, 
thrifts are the dominant originator of adjustable rate mortgages 
(ARM's). In the first quarter, roughly 69 percent of all new ARM 
originations were made by thrifts.\4\
---------------------------------------------------------------------------
    \4\ Mortgage origination market share estimates based on data from 
the Mortgage Bankers Association of America and the Federal Housing 
Finance Board.
---------------------------------------------------------------------------
    The industry originated $74.3 billion in single-family mortgages in 
the first quarter, the second highest quarterly volume on record. Since 
the end of 1995, the industry has originated over $1 trillion in 
single-family home loans.
    Single-family mortgage loans and related securities comprised 
almost two-thirds of thrift assets in the first quarter. In addition, 
4.7 percent of thrift assets were held in multifamily mortgages, 
bringing the percentage of assets held in residential-related loans and 
securities to 70.1 percent.
    While thrifts are primarily residential mortgage lenders, they have 
become more active in consumer and commercial business lending. The 
industry's ratio of consumer loans-to-assets was 6.3 percent in the 
first quarter, up from 4.5 percent at the end of 1990. Utilizing the 
expanded small business lending authority granted by the Economic 
Growth and Regulatory Paperwork Reduction Act of 1996, the industry's 
ratio of commercial loans-to-assets stood at 3.0 percent in the first 
quarter, up from 1.5 percent at the end of 1997.
    Thrifts also help their communities by making mortgages on 
hospitals, nursing homes, farms, churches, stores, and other commercial 
properties. Such loans comprised 4.0 percent of thrifts' assets in the 
first quarter.

2. Full Range of Financial Services
    Besides loans and deposits, thrifts provide a wide range of savings 
and investment products to their communities. The industry's sales of 
mutual funds and annuities, and trust assets administered, have risen 
dramatically over the past 5 years. Total sales of mutual funds and 
annuities were $2.9 billion in the first quarter of 2001, and $12.8 
billion for the year 2000, compared to $6.4 billion in 1995. Trust 
assets administered totaled $427.4 billion as of the first quarter 
versus $13.6 billion at the end of 1995.

III. Risks Facing the Industry

A. Credit Risk
    While the overall financial condition of the thrift industry is 
strong, the current economic slowdown suggests that rising levels of 
delinquent loans are a distinct possibility. In terms of credit risk, 
the industry's largest exposure is in residential mortgage loans. 
Fortunately, however, the housing market is very strong in most areas 
of the country and delinquencies on single-family residential loans 
have remained at very low levels. Barring a serious downturn in the 
economy, which seems unlikely, the credit quality of residential 
mortgage portfolios should remain healthy.
    The slowdown in economic activity, however, is bound to have a bad 
effect on marginal credits, particularly overextended consumers and 
commercial borrowers.
    Thrifts are not immune to weakness in the business sector since 3.0 
percent of thrift assets are held in commercial loans. Nor is the 
industry immune to problems in the consumer sector. In recent years, 
debt service burdens of consumers have generally grown more rapidly 
than their incomes, and the rate of consumer savings of disposable 
income has been disturbingly low.
    Not surprisingly, banks and thrifts have been tightening credit 
standards, building loss reserves, and otherwise fortifying their 
balance sheets. As we have learned from experience, it is not 
sufficient to rely solely on bank and thrift managers to ensure the 
safety and soundness of the system. Vigilant supervision is important, 
particularly in a banking system such as ours where deposit insurance, 
together with ever-tougher competition, can blunt market discipline and 
encourage undue risk-taking by some institutions.
    Given the current economic environment, we are placing increased 
emphasis on credit review in our examination process. OTS examiners are 
focusing on thrifts' credit quality, reserve policies, and capital 
adequacy. The loan monitoring, loan collection, and work out procedures 
of thrifts are being given increased scrutiny. Particular attention is 
being given to business-related loans originated during the height of 
the economic expansion.

B. Liquidity Risk/Funding Changes
    We are also closely monitoring thrifts' liquidity, although it 
should be stressed that liquidity problems are rare in the industry, 
and when they do occur, are invariably triggered by weaknesses such as 
problem loans.\5\ While an insured depository institution is solvent 
and has eligible collateral, liquidity is available. Nevertheless, the 
thrift industry as a whole has become decidedly more dependent on 
wholesale funding in recent years, and loan-to-deposit ratios have been 
increasing. These trends reflect the recent slow pace of deposit growth 
as well as our very competitive financial markets in which banks and 
thrifts must carefully balance the trade-off between liquidity and 
profitability.\6\
---------------------------------------------------------------------------
    \5\ On March 15, 2001, OTS issued an interim rule to implement the 
recent repeal of the statutory liquidity requirement. The rule removes 
the regulation that requires savings associations to maintain an 
average daily balance of liquid assets of at least 4 percent of its 
liquidity base.
    \6\ On May 11, 2001, OTS and the other Federal banking agencies 
issued an advisory on the risks of brokered and other rate sensitive 
deposits. On June 8, 2001, OTS issued Examiner Guidance on wholesale 
borrowings. On June 19, we issued a Thrift Bulletin that outlines sound 
principles for liquidity management. That bulletin stresses the 
importance of liquidity policies and procedures, management oversight, 
contingency planning, and scenario analysis.
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C. Operational Risk
    Operational risk, which includes the risk of loss due to technical 
failures and human error, seems to be an ever-present and growing 
concern in the financial services industry. The growth of internet 
banking, the outsourcing of core banking functions, and the rapid pace 
of technological and financial innovation has created new challenges 
and concerns.
    Advances in technology have also created opportunities for thrifts, 
especially in the areas of marketing and broadening customer services. 
Thrifts also utilize technology to increase their understanding of 
certain credits, enabling better product pricing. The use of technology 
for these purposes is encouraged but must be done so responsibly.
    Our IT examiners, and increasingly, technology-trained safety and 
soundness examiners, focus on how well thrifts' use of technology are 
designed and monitored to minimize operational risk and ensure thrift 
and customer security and privacy.
    Given the recent financial difficulties experienced by many ``high-
tech'' companies, thrifts' contingency planning is receiving increased 
supervisory attention.\7\
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    \7\ On June 11, 2001, OTS published a request for comment pursuant 
to section 729 of the Gramm-Leach-Bliley Act. OTS and the other Federal 
banking agencies are studying their regulations on the delivery of 
financial services. The purpose of the study is to report findings and 
conclusions to Congress, together with recommendations for appropriate 
legislative or regulatory action to adapt existing requirements to 
online banking and lending.
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D. Increasingly Competitive Environment
    The increasingly competitive environment in the financial services 
industry has forced thrift executives to search not only for ways to 
cut costs but also for new business opportunities, which often have a 
more extreme risk/return profile than the traditional thrift business. 
Subprime lending, whether home equity or credit cards, is one such 
business. Well-managed subprime lending, with responsible marketing, 
pricing and terms, is an important element in expanding credit access. 
But the business is fraught with danger for consumers, institutions, 
and the deposit insurance funds when an excess of zeal for short-term 
profitability overcomes responsible management and monitoring, 
including adequate reserving and capitalization.\8\
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    \8\ On January 31, 2001, OTS and the other Federal banking agencies 
issued expanded guidance intended to strengthen the examination and 
supervision of institutions with significant subprime lending programs. 
The guidance supplements previous subprime lending guidance issued 
March 1, 1999.
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    Guiding an institution through these shoals successfully is, of 
course, the responsibility of each institution's management and board 
of directors. The willingness of management and directors to understand 
and manage risk is one of the primary underpinnings of a safe and sound 
operation. A key part of OTS's supervisory strategy is to hold regular 
meetings with senior thrift managers. OTS's regional supervisory staffs 
meet regularly with thrift senior managers during onsite examinations 
and to discuss items of supervisory interest. OTS also holds meetings 
and conferences with senior managers from multiple thrifts to share 
ideas and discuss trends affecting the industry. During the past 18 
months, OTS held 24 town meetings involving 240 thrifts; 20 Financial 
Management Seminars with 740 attendees; five Directors' Forums that 
attracted 1,275 attendees; and a Leadership Conference attended by over 
400 thrift CEO's and directors from about 250 institutions.
    Thrift senior managers at these meetings voiced several common 
issues. First and foremost was that thrifts operate in a very 
competitive environment, especially in the conforming single-family 
mortgage market. This means thrifts need to think and plan 
strategically, especially given the country's changing economy and 
demographics. To ensure long-term profitability and earnings growth, 
many thrift managers are focused on finding new markets to serve and 
analyzing new business lines. These managers strongly feel that niche 
markets, emerging markets, and markets neglected or forgotten after 
``mega mergers'' reduced local banking presence offer good 
opportunities for profitable expansion.
    Each thrift must adopt its own strategy to compete in an 
increasingly competitive environment. Our examination focus is to 
ensure that thrifts have the requisite managerial expertise, sound 
policies and procedures, and adequate systems before entering new lines 
of business. We also follow up to ensure that institutions effectively 
manage and monitor these business lines once entered.

IV. OTS Focus During the Next Twelve Months

A. Ensure Problem Thrifts Have Capable Management
    Onsite examinations and regular offsite financial monitoring are 
two of the tools we use to keep on top of issues and institutions, and 
ensure thrift management and boards of directors are adequately 
addressing weaknesses. Two other supervisory tools that we use to 
monitor problem institutions are the Regional Managers Group meetings, 
which happen 10 times a year, and high-risk videoconferences, which 
happen 3 times a year for each region--a total of 15 3- to 5-hour 
meetings to discuss high risk or high profile institutions each year. 
These tools enable us to learn from each other, enhance consistency 
across the country, and stay on top of problem institutions, while 
retaining primary responsibility for supervision in our regions.

B. Functional Regulation
    OTS has made a considerable effort in the last several years to 
reach out to other State and Federal functional regulators to 
coordinate and streamline the potential overlapping regulatory 
interests. These activities involve meetings, regular communications, 
and joint activities and programs, often through various supervisory 
coordinating entities such as the National Association of Insurance 
Commissioners (NAIC), the National Association of Securities Dealers 
(NASD), and the North American Securities Administrators Association 
(NASAA).
    We have worked extensively over the last several years with the 
NAIC to coordinate the regulatory overlap that has developed with 
increased insurance company acquisitions of thrift institutions. As a 
result of this coordination, OTS has in place information sharing 
agreements with 45 State insurance regulators. These efforts include 
frequent appearances by OTS and NAIC officials at programs sponsored by 
OTS and by the NAIC or by individual NAIC State members. We have also 
sponsored several joint programs. OTS's senior managers have attended 
NAIC training sessions on the State insurance regulatory system. 
Likewise, the State insurance commissioners, their staff, and NAIC's 
staff attended an OTS-sponsored training program about the thrift 
regulatory system.\9\ Our Regional Directors have working relationships 
with insurance commissioners in States in their region where insurance 
companies that own thrifts are domiciled.
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    \9\ OTS and the other Federal banking agencies issued final 
consumer protection rules for the sale of insurance products by 
depository institutions on December 4, 2000. The final rule implements 
section 305 of the Gramm-Leach-Bliley Act. As required by the statute, 
the agencies consulted with the NAIC.
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    OTS's regional staff also coordinate closely with their regional 
counterparts at the NASD on issues of common interest involving 
securities activities by thrift service corporations engaged in 
securities brokerage activities. Similarly, we have developed a good 
working relationship with staff of the NASAA that enables us to 
coordinate and leverage our resources to achieve success in areas of 
mutual interest. We continue to work with the SEC on policy matters 
(such as the privacy regulations required under the Gramm-Leach-Bliley 
Act) and, occasionally, on matters involving specific institutions.

C. Coordination With Other Federal Banking Agencies (FBA's) and
State Banking Regulators
    OTS also works closely with other FBA's and State bank regulators, 
both through the Federal Financial Institutions Examination Council 
(FFIEC) and individually, where appropriate, to identify emerging 
issues in the financial institutions industry and to coordinate 
supervisory activities. This activity occurs both in Washington and at 
the regional level, directly with other regulators and through the 
Conference of State Bank Supervisors (CSBS). Topics of mutual interest 
include emerging risks, adverse trends, and other supervisory matters. 
This is a mutually beneficial relationship that keeps all parties 
apprised of potential problems, emerging issues, and possible overlaps 
of regulatory authority that may pose potential regulatory burdens or 
gaps in regulatory coverage.\10\ For example, in connection with 
proposed OTS regulations on mutual savings associations and mutual 
holding companies, we have met with seven State banking commissioners. 
CSBS was very helpful in arranging these meetings.
---------------------------------------------------------------------------
    \10\ OTS supervises 148 State-chartered savings associations and 32 
thrift holding company structures whose thrifts subsidiaries are all 
State-chartered. This role, which is similar to that of the FDIC and 
the Federal Reserve with respect to State-chartered commercial banks 
and savings banks, requires significant coordination with State bank 
regulators on a day-to-day basis in our regions.
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    In matters involving preemption, we notify the appropriate State 
regulator to obtain their views when an institution asks us to opine 
that HOLA preempts a particular State regulatory action. If we issue an 
opinion we send a copy to the State regulator and CSBS.

D. Keep Supervisory Staff Well Trained and Informed
    Another aspect of our regulatory oversight is OTS's focus on 
dynamic, needs-based employee training. We have inventoried the skill 
sets possessed by all of our examiners and, utilizing that information, 
are able to identify needed areas of training. This typically involves 
a periodic assessment by regional supervisors of upcoming and emerging 
issues at institutions in the region, an assessment of the strength of 
regional examiners in the skills required to address these needs, and 
training targeted to address areas of need. Our new Professional 
Development Program, geared to enhancing individual competencies and 
skills; specialty examiner tracks; accreditation programs; and a soon-
to-be-piloted management development program, keep employee skills at 
top levels.
    OTS examiners typically receive training several times annually. 
Our training is designed for maximum impact with minimum disruption to 
the day-to-day operations of the agency. Training is delivered in 
various forms, including computer-based programs, videoconferencing, 
outside programs, and by pooling specialized examiner resources so 
individuals can share their expertise nationally within the agency. 
Both our trust and IT examiners, although regionally based, work across 
the country, and the agency's credit card specialists are always on 
call to deal with this specialized set of risks. During 2000, examiners 
worked cross-regionally for a total of almost 800 days, and we had 19 
details to Washington. These exchanges enhance the skills and 
perspective of both the sending and recipient offices.
    In addition to our internal training activities, we work closely 
with the other FFIEC agencies to identify areas that warrant more 
extensive and coordinated training initiatives. This past year, the 
FFIEC piloted the concept of just-in-time training on CD to get 
training on hot issues such as subprime lending and privacy out quickly 
to a wide audience. We hold staff conferences and teleconferences to 
promote sharing of ideas and experiences among supervisory staff. We 
are also improving our information systems to simplify and expedite 
access to internal and publicly available thrift and market 
information.

E. Early Warning Systems
    We are increasing our use of offsite early warning systems to help 
pinpoint potential problem areas. In addition to our Net Portfolio 
(NPV) Model, OTS examiners and analysts utilize our Risk Assessment 
Model (RAM) and our recently implemented Risk Monitoring System (RMS) 
to assist offsite financial analysis. Both risk identification models 
utilize financial ``triggers and hits'' to quickly identify areas that 
need special attention and analyses. The RMS also provides our 
examiners and analysts with direct links to thrift web sites, thrift 
stock price data, SEC filings, and general economic information, all 
used to closely monitor and analyze thrift operations between onsite 
exams.

V. Items for Legislative Consideration
    We are developing a list of legislative proposals for your 
consideration that would reduce regulatory burden on the thrift 
industry, streamline and improve OTS supervisory authority, and make 
technical corrections. The items we are studying include:

 Statutory authority for a Deputy Director of OTS. This would 
    avoid the potential for gaps in OTS regulatory and enforcement 
    authority if there is a vacancy in the office of the Director. This 
    is particularly important because of the delay inherent in filling 
    vacancies for Presidential appointments.
 Permitting Federal thrifts to merge and consolidate with their 
    nonthrift subsidiaries directly. Today, a Federal thrift may only 
    merge with another depository institution. We have recently learned 
    of a situation where current law will cost the institution an 
    estimated $11 million to structure a merger in a way that is 
    consistent with existing law.
 Modernizing thrift community development investment authority 
    to permit investments to promote the public welfare and remove 
    obsolete provisions based on HUD programs that have been off the 
    books for 20 years.
 Eliminating the requirement that a service company subsidiary 
    of a thrift must be organized under the laws of the State where the 
    home office of the thrift is located. This geographic restriction 
    was imposed before interstate branching, the Internet, and 
    telephone banking, and today simply serves no useful purpose.
 Enhanced small business and consumer lending authority to 
    enable thrifts to better serve the credit needs of their 
    communities.
 An exception from broker-dealer registration by thrifts 
    equivalent to the exception that banks have under the Securities 
    Exchange Act of 1934. The SEC has issued an interim rule 
    accomplishing this result, but it may be appropriate to confirm the 
    change by statute.
 An exception from investment adviser registration by thrifts 
    equivalent to the exception that banks have under the Investment 
    Advisers Act of 1940. The SEC has announced it is considering 
    rulemaking to address this issue, but, as with the broker-dealer 
    exception, a confirming statutory amendment appears appropriate.

    After our final policy reviews and consultation with other affected 
agencies, we plan to submit a package of legislative proposals with a 
recommendation for their enactment.

VI. Conclusion
    Over the past several years, the thrift industry has expanded and 
diversified while achieving strong financial results. At OTS, we have 
used this time to ensure that our staff and technology is poised to 
deal with new risks and to assist the institutions we supervise as they 
move into new areas, so they are properly focused on long-term 
profitability and responsible service to their customers and 
communities. The challenges continue, but both the industry and the 
agency are well-positioned to meet them.

  RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES FROM ALAN 
                            GREENPAN

Q.1. What do you think is the single greatest potential problem 
facing the U.S. financial system today?

A.1. Considering the challenging economic environment of recent 
months, our financial system remains in remarkably good shape. 
Certainly an important concern facing the U.S. banking system 
is the deterioration in credit quality. Much of the erosion is 
the result of a weakening in underwriting standards, especially 
in the 1996-1998 period. To date, financial institutions have 
shown the capacity to absorb emerging problems in severely 
affected segments of their loan portfolios. Problems have been 
for textiles, health care, media, agriculture, computer, 
telecommunications and other technology segments. More broadly, 
other segments of bank loan portfolios, including corporate, 
real estate, and consumer portfolios, have shown only moderate 
weakness to date. Should the domestic economy slow further or 
contract, the performance of these portfolios could deteriorate 
placing pressure on the earnings and, if the downturn were 
severe, potentially the capital bases of financial 
institutions.
    At the present time, the U.S. financial system is better 
prepared to enter a period of economic weakness than in the 
past by virtue of stronger capital bases, loan loss reserves 
and more active risk-management techniques. Despite the 
increase in problem credits, financial institutions have also 
continued to provide credit to sound borrowers. Still, 
financial institution managers, regulators and policy makers 
must remain vigilant for deteriorating conditions and take 
necessary actions to address emerging problems so that these 
institutions are able to continue to perform their essential 
intermediation function for the U.S. economy even under weaker 
conditions.

Q.2. While many analysts predict a recovery from the current 
economic slowdown in the second half of the year, there is 
still a chance that the downturn could be worse than expected. 
If the economy were to underperform, what consequences would 
that have for the safety and soundness of the banking system?
    Specifically, I would like to ask about the banking 
system's risk exposure in the following areas:

 Noncurrent Loans
 Credit Card and Consumer Loans
 Mortgage Delinquencies
 Telecommunications Sector

A.2.
Noncurrent Loans
    Please see the answer to question 3.
Credit Card and Consumer Loans
    With regard to the risk exposure from credit card and 
consumer loans, these loans amount to about 10 percent of bank 
balance sheet assets, though another 5 percentage points is 
also held indirectly through credit card securitizations. Over 
the past decade, banking organizations have taken advantage of 
scoring models and other techniques for efficiently advancing 
credit to a broader spectrum of consumers and small businesses 
than ever before. In doing so, they have made credit available 
to segments of borrowers that are more highly leveraged and 
that have less experience in managing their finances through 
difficult periods. In recent years, intense competition for 
customers and the expansion of credit to weaker or more highly 
leveraged segments resulted in record net charge-off levels for 
credit card portfolios. In the last 2 years, net charge-offs 
have declined to a lower level but are still moderately above 
average. Nevertheless, this particular business line remains 
highly profitable for most banks as higher interest rates on 
credit card loans are offsetting higher credit costs. In 
addition, with the recent slowdown in the economy, rising 
personal bankruptcies, an increasing unemployment rate, and a 
modest deterioration in loan quality, lenders have tempered 
their outlook, tightening their standards somewhat for credit 
cards and other consumer loans.
    Should the economy weaken further, credit card net charge-
offs would likely rise, possibly fairly rapidly. The effect on 
individual banks would depend largely upon the portion of 
leveraged consumers in their credit card portfolios. Banks 
would feel earnings pressure both directly from credit cards 
funded on balance sheets and from lower noninterest income on 
securitized credit cards. In extreme cases, high charge-off 
rates could trigger early amortization clauses of securitized 
credit card pools, causing a rapid return of credit card 
receivables to bank balance sheets, resulting in both credit 
and liquidity pressures. At present, given current capital 
levels, strong earnings, and adequate reserves, deterioration 
in the consumer portfolio is most likely to be more of an 
earnings issue than a capital concern.

Mortgage Delinquencies
    Credit quality for mortgage loans has eroded somewhat in 
recent periods, but remains historically in line with the 
healthy quality of the past several years. During the first 
quarter, noncurrent mortgage loans totaled 0.95 percent of the 
portfolio at insured commercial banks, compared to 0.90 percent 
at year end and were roughly equal with the level at year end 
1997. Since the collateral for the vast majority of mortgage 
loans is the borrower's residence, borrowers tend to attempt to 
remain current on their mortgages even during difficult times. 
Consequently, mortgage loans tend to perform better during 
tougher economic times than other consumer loans. Moreover, 
though certain residential housing markets have experienced 
price weaknesses during downturns, the loss experience on 
mortgage loans has generally been modest. For example, in 1991 
the proportion of mortgage loans that were noncurrent totaled 
1.64 percent, with total portfolio net charge-offs a modest 17 
basis points.

Telecommunications Sector
    Please see the answer to question 6.

Q.3. After 5 very good years, the rate of nonperforming 
commercial, industrial, and personal loans increased by 26.6% 
in 2000. Can you please tell me what stress, if any, this 
places on the banking system, and whether or not you expect a 
similar rate of increase for this current year?

A.3. At present, the banking system is better prepared for a 
potential further softening in the economy than in past 
decades. For example, just prior to the last recession, the 
overhang of effects from problem developing country loans and 
mounting commercial real estate problems at insured commercial 
banks resulted in noncurrent \1\ loans totaling 3.7 percent of 
total loans; that compares to just 1.2 percent today. Moreover, 
in 1990 noncurrent loans amounted to nearly 30 percent of tier 
1 capital and reserves, compared to 8.6 percent at the end of 
the first quarter of 2001. In addition, bank earnings relative 
to assets were just 48 basis points in 1990 compared to the 120 
achieved in 2000 and 128 in the first quarter of 2001, despite 
higher provisions from weakening asset quality. In addition, 
1990 earnings were much more dependent on loan quality, while 
earnings today are more diversified.
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    \1\ Loans 90 days or more delinquent or nonaccruing.
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    During 2000, noncurrent loans at insured commercial bank 
rose by 30 percent, and in the first quarter of 2001 were up by 
an annualized 33 percent. It is likely that noncurrent loans 
will continue to rise throughout the course of 2001 and perhaps 
into early 2002 as well before peaking. However, at that rate 
of growth such deterioration would generally place pressure on 
bank earnings, but not on capital adequacy.

Q.4. Though the delinquency rates for credit cards and consumer 
loans are well below the high levels experienced during the 
last economic downturn, they have risen back to levels 
comparable to 1993. What do you think the effects of this 
increase in delinquency rates will be, with regard to both 
consumers and the financial institutions that you regulate?

A.4. Delinquency rates on a variety of consumer loans have 
returned to high levels in recent periods and do suggest 
increased strain on the finances of some U.S. households. As 
indicated in the response to question 7, these pressures also 
appear in historically high levels of debt service burden and 
personal bankruptcies are at an elevated level. Although 
measures of household net worth continue to be benefitted from 
higher home prices, important questions remain about the 
willingness and ability of consumers to sustain recent trends. 
Through the first quarter, the deterioration in consumer loan 
portfolios remains within the range of what would normally be 
expected during a period of economic weakness and does not 
appear particularly threatening either to U.S. households or 
their lending institutions. Continued slippage, however, could 
cause heightened concern. Through 2000 and for the first 
quarter of this year, credit card net charge-off rates for 
insured commercial banks were only modestly above the average 
loss rate for the decade of the 1990's and were below the peak 
rates of 1997 and 1998. Loss rates on installment loans have 
been at moderately high levels since 1997 (around 1.04 percent) 
without notably disruptive effects, but have increased in the 
first quarter of 2001, to 1.20 percent.
    Overall, consumer lending (including securitized credit 
card receivables that are managed, but off-balance sheet) 
represents about 15 percent of commercial bank assets, with 
most exposures relating to credit cards. Although most credit 
card exposures, in turn, are held by roughly 30 so-called 
``credit card banks,'' those institutions remain both highly 
profitable and are typically owned by larger, well-diversified 
banking organizations. The earnings and capital bases and 
increasingly sophisticated risk-management practices of both 
the credit card banks and their parent institutions mitigate 
supervisory concerns related to the consumer sector. Recent 
Federal Reserve surveys of bank lending practices and other 
supervisory indicators also suggest that lenders are closely 
monitoring their exposures and are tightening standards and 
terms on consumer loans in response to declining quality. As 
noted in response to question 2, any deterioration in the 
strength of consumer loan portfolios will most likely be 
limited to the banks' reported earnings rather than their 
capital.

Q.5. According to a Mortgage Bankers Association survey, 10% of 
mortgages backed by the Federal Housing Administration are now 
30 or more days delinquent. An article in the June 12 New York 
Times stated that, ``The mortgage problems underscore one main 
reason many policymakers and economists are so concerned about 
whether the United States will enter a recession this year.'' 
Can you please tell the Committee your thoughts and concerns 
about the high level of mortgage delinquency?

A.5. While delinquencies by FHA mortgage holders jumped several 
quarters ago, mortgage delinquencies by holders of conventional 
mortgages, by far the larger share of the market, have risen 
only slightly during this time. That said, one must still be 
concerned about the recent sharp increase in FHA delinquencies 
because many FHA borrowers would likely be among the first 
households adversely affected by an economic slowdown, and the 
situation bears close watching to see if mortgage delinquency 
becomes more prevalent among conventional mortgage holders.

Q.6. I have heard from varying persons that the banking 
industry has significant exposure in the telecommunications 
sector. What is the direct and indirect exposure of banks to 
the fall-out in the telecommunications sector?

A.6. The banking industry has been active in underwriting bonds 
and originating large credit facilities for the 
telecommunications sector. During the recent telecommunication 
expansion, the banking industry has worked to syndicate credits 
to a diverse array of investors, thus spreading and 
diversifying risk within and outside of the U.S. banking 
industry. In practice, the originating agent bank retains only 
a small portion of the underlying credit by participating out 
the vast majority of the commitment to other U.S. and foreign 
banking organizations, asset managers, and insurance companies. 
In addition, bank loans are generally more senior to bond 
holders in bankruptcy so that the severity of losses upon 
default tends to be less severe than for other creditors. In 
addition, these loans are generally structured with covenants 
that can limit further draws on the outstanding commitment if 
the borrower's condition deteriorates.
    In particular, based on data from the interagency Shared 
National Credit program for 2001, the 10 largest U.S. bank 
holding companies had outstanding telecommunication balances 
relative to tier 1 and reserves ranging from as little as 1.8 
percent to as high as 18.1 percent. Including commitments to 
lend, which some telecommunication companies may be unable to 
draw, exposures ranged from 5.7 percent to 43 percent of tier 1 
capital and reserves. It should be noted that the 
telecommunications industry has a number of different segments 
not all of which are experiencing difficulties. In addition, 
much of the credit is to borrowers with investment grade credit 
ratings.
    That said, signs of weakness in the telecommunications and 
other high technology sectors are troubling and could place 
pressure more broadly on the U.S. economy should layoffs in 
this sector continue and should the effects of a pull back in 
technology investment spillover into other sectors. In 
particular, in the first quarter of this year, there has been a 
pronounced increase in nationwide office vacancies that has 
resulted in a negative net absorption of office space in the 
United States. That poor performance, the worst in 20 years, 
has been attributed by some market observers to the abrupt 
return of office space to the market by technology firms and to 
delays by prospective tenants hoping that softening conditions 
will lower rents further. Whether the first quarter represents 
a temporary phenomenon or the beginning of a longer-term trend 
remains to be seen, but the need for institutions to continue a 
realistic assessment of conditions and stress test their 
portfolios is paramount.
    As emphasized earlier, the banking industry is well 
positioned to meet emerging asset quality weaknesses. As 
telecommunication and other technology firms reassess their 
business strategies to better reflect current market 
conditions, creditors will be challenged to ensure that they 
make appropriate risk-return tradeoffs while continuing to 
provide credit to sound borrowers.

Q.7. According to the OCC, consumers are more highly leveraged 
now than at any measured point in history. Not only are debt 
service payments at historic highs, but the increase in debt 
has been financed through instruments other than mortgages. 
Credit card debt is rising very rapidly; the Chicago Sun-Times 
reported that the average credit card debt per household is 
$8,123 and has grown threefold over the past decade. Debt 
service payments constitute over 14% of disposable income. What 
do you believe the effects of this high level of personal debt 
will be with regard to consumers, the banking sector, and the 
economy as a whole? If the economic downturn is worse than 
expected, what would be the effect of having so many people so 
highly leveraged?

A.7. Over the past 2 years, mortgages and other types of 
consumer debt have increased substantially more rapidly than 
disposable income. As a result, the debt service burden, 
defined as the ratio of required payments on mortgages and 
other types of consumer loans to disposable income, is close to 
14\1/2\ percent--the top of the range seen in the 20 year 
history of this series. However, even with these large 
increases in household debt, the dramatic gains in household 
assets in recent years have pushed household net worth (assets 
minus liabilities) to a high level by historical standards. 
According to the latest published data, household net worth at 
the end of the first quarter of this year was about five and a 
half times disposable personal income, up from about five times 
disposable personal income at the beginning of 1996.
    That said, there are signs that the economic slowdown has 
put some households under increased financial strain. For 
example, bankruptcy filings have run at an elevated rate this 
year, and some measures of delinquencies on loans to 
households--including, for example, those on mortgages 
described in the answer to question 5--have increased recently. 
If this strain were to worsen or become more widespread, 
households might curtail the growth of their spending further, 
which would dampen increases in overall output. As a result, 
the Federal Reserve continues to monitor carefully household 
financial positions.

Q.8. Remittances are a large and growing economic reality that 
affect millions of people both in America and south of the 
border. It has recently come to my attention that this 
industry, which recent estimates have put at more than $20 
billion annually, often charges high fees and that many of the 
leading companies have been challenged in court for having 
hidden fees. In a New York Times article it is stated that 
``the fees have run from about 10 percent to 25 percent or 
more.'' Do you believe that there are problems in the manner in 
which the bulk of remittances are made today? What steps has 
your agency taken to analyze possible solutions including 
fostering or creating alternative transfer mechanisms?

A.8. Both banks and nonbanks in the United States currently 
provide cross-border money transfer services to residents of 
the United States. These services include traditional 
electronic wire transfers between a U.S. bank and its overseas 
correspondent using telecommunications networks such as SWIFT; 
electronic money transfer services provided by nonbanks such as 
MoneyGram or Western Union; ATM withdrawals overseas using 
international EFT networks to debit the cardholders' U.S. bank 
accounts; and other emerging networks.
    The fees associated with cross-border remittances by 
individuals may include charges for initiating the transfer 
itself, charges to convert U.S. dollars to a foreign currency, 
and sometimes, fees for the receipt of funds by beneficiaries. 
Fees may vary by service provider, service, point of origin, 
point of destination, amount of money sent, and the method of 
funding the payment. Based on a quick, informal survey of a few 
nonbank money transmitters, we found the quoted fees ranged 
from $6 to $15 for transfer amounts of $100 and from $15 to $68 
for transfer amounts of $1,000, depending on the destination 
country and the service used. Currency exchange charges are 
additional if delivery is to be made in the local currency. 
Receivers are not charged any fees according to the surveyed 
institutions.
    By comparison several large U.S. banks have said they 
charge between $35 and $45 to send a consumer international 
wire transfer and typically add foreign exchange charges if the 
money is to be delivered in the local currency. Additional 
charges also may be imposed on beneficiaries by the receiving 
bank for delivery of funds. In the cross-border context, bank 
charges for consumer wire transfers can frequently be higher 
than the fees charged by nonbank money transmitters due to 
lower volumes of activity, additional handling costs, and 
correspondent banking fees.
    At the present time, the market appears to provide 
consumers with several accessible, rapid, and efficient cross-
border transfer services. As a result of increasing competition 
and growing volumes of remittances, fees for making cross-
border consumer transfers also appear to be decreasing, 
although costs still vary significantly across companies and 
countries. Looking ahead, the technological change and the 
projected strong growth of overseas remittances may well 
continue to increase competition, decrease processing costs, 
lower fees, and increase the number of alternatives for making 
cross-border transfers.
    For its part, the Federal Reserve continues to analyze 
issues related to cross-border payments, including alternatives 
to promote greater efficiency. For example, the Federal Reserve 
has been exploring whether general improvements could be made 
in handling cross-border funds transfers using the automated 
clearing house (ACH), a system by which many U.S. consumers 
receive electronic payroll deposits and Government benefits. 
The Federal Reserve recently launched a service for sending 
cross-border payments to Canada through the ACH and, later this 
year, will be investigating the feasibility of crossborder ACH 
payments with Mexico and other countries. In addition, the 
Federal Reserve is working closely with industry groups on 
potential improvements to cross-border payments. One such 
industry effort, lead by the National Automated Clearing House 
Association, an industry group, is a global effort to improve 
cross-border ACH payments, known as WATCH (Worldwide Automated 
Transaction Clearing House). The Federal Reserve has also been 
in discussion about the cost, timing, and transparency of 
cross-border transfers with other central banks, most recently 
through the G-10 central banks' Committee on Payment and 
Settlement Systems.

Financial Literacy and Education
Q.9. Former Treasury Secretary Summers has stated that ``all 
high school students should receive a financial education,'' 
and that ``though personal financial education must begin in 
the home, it must continue in the schools.'' Can you please 
comment on the state of financial literacy and education among 
Americans, including any deficiency in this area that should be 
addressed? If you see any deficiencies, what do you believe can 
and should be done with regard to these deficiencies in both a 
broad sense and with regard to your agency? At the hearing I 
asked for information regarding any initiatives that your 
agency has taken, including the Money Smart program. Could you 
please provide this information in your submission to the 
record?

A.9. Recent studies by the Jump$tart Coalition and the Consumer 
Federation of America confirm that gaps in financial literacy 
levels exist among both youth and adults. The Jump$tart 
Coalition found that, on average, students in a 2000 financial 
literacy exam answered only about 52 percent of the questions 
correctly. The Consumer Federation of America administered a 
consumer literacy quiz to 1,700 adults nationwide; the average 
score was 75 percent correct.
    Our sense is that programs and resources for dealing with 
these gaps in financial literacy are plentiful. For example, 
surveys by the Woodstock Institute and the Fannie Mae 
Foundation indicate that numerous school and community-based 
programs focus on financial literacy (see Tools for Survival: 
An Analysis of Financial Literacy Programs for Lower-Income 
Families [2000], Woodstock Institute; and Personal Finance and 
the Rush to Competence: Financial Literacy Education in the 
U.S. [2001], Fannie Mae Foundation).
    The major difficulty seems to be in bringing people, 
programs, and resources together in a timely and meaningful 
way. Partnerships among organizations and groups are one 
approach to addressing this difficulty. The Federal Reserve is 
participating in financial literacy partnerships at several 
levels. The Board is represented on the Board of Directors of 
the Jump$tart Coalition, and a majority of the Federal Reserve 
Banks are members of the State coalitions of Jump$tart. For 
example, staff at the Federal Reserve Bank of New York led a 
public/private network to encourage the New York State 
Department of Education to incorporate personal financial 
literacy into the mandated high school economics curriculum for 
the State of New York.
    Board staff have been engaged over the past year in 
discussions with colleagues in the National Partnership for 
Financial Empowerment, a nonpartisan coalition initiated by 
Treasury, and serve on two work groups on minority outreach and 
working with Native Americans.
    Across the System, Federal Reserve staff based in our 
Community Affairs and Public Information programs work with 
community development organizations and school systems to 
provide 
financial and economic education resources to the community.
    Initiatives such as the Federal Reserve System's Project 
Money Smart (developed by the Federal Reserve Bank of Chicago) 
and Building Wealth (developed by the Federal Reserve Bank of 
Dallas) are designed to provide information in printed 
brochures and through their web sites, with links to a wide 
variety of financial literacy resources. On the Project Money 
Smart web site, for example, consumers are linked to 
information on budgeting, savings, credit, mortgages, and 
financial institutions. On the Building Wealth web site, 
consumers can compare different savings and investment choices 
and calculate the future value of their savings.

Q.10. What steps has the Federal Reserve taken to promote 
technology and innovation in the payments system, and what 
steps should it take? As well, are you concerned that the 
initiation of payments on the Internet, or through another 
electronic means, could affect the safe operation of the 
payment systems?

A.10. The Federal Reserve has taken a number of steps to 
promote technology and innovation in the payment system. With 
respect to its own systems, the Federal Reserve has 
consolidated the number of its computer centers and centralized 
software over the past decade to reduce costs and increase the 
efficiency of its electronic payment systems. These initiatives 
have enabled the Federal Reserve to cut the prices for its 
electronic payment services by more than half since the mid-
1990's.
    The Federal Reserve is also adapting services to use 
Internet protocols and web technology internally and for 
communicating with customers. In addition, the Reserve Banks 
are using web technology to make some low-risk services (for 
example, cash ordering, savings bond purchases, and check 
information) available via the Internet.\2\ In the future, the 
Reserve Banks may consider offering higher risk services (for 
example, Fedwire funds transfers) through the Internet or an 
extranet if sufficient security and quality of service could be 
guaranteed.
---------------------------------------------------------------------------
    \2\ The Reserve Banks are also conducting a pilot to enable banks 
to originate off-line book-entry securities transactions over the 
Internet.
---------------------------------------------------------------------------
    Given the large number of checks that continue to be 
written in this country (roughly 70 billion a year), the 
Federal Reserve has also focused significant attention to using 
technology to improve the efficiency of the check system. The 
Federal Reserve has played a leadership role for many years in 
the development of the technology and associated standards for 
capturing, exchanging, and storing check images. More recently, 
the Federal Reserve Banks have been participating in a 
multiyear project to create a standard for their check 
processing operations and to enhance electronic check services, 
such as the delivery of check data and images to its bank 
customers.
    The Federal Reserve is also taking additional steps to 
promote the use of electronics in payments services in the 
belief that such payments can be less costly and more efficient 
than paper-based payments. Earlier this year, for instance, 
Board staff revised its commentary to Regulation E, which 
implements the Electronic Fund Transfer Act, to clarify 
requirements for authorizing electronic fund transfers and for 
using the Internet to enroll customers in electronic bill 
payment arrangements, as well as how the regulation applies to 
certain electronic transactions.
    The Board has also asked the Payments System Development 
Committee (co-chaired by Vice Chairman Roger Ferguson and 
Federal Reserve Bank of Boston President Cathy Minehan) to work 
collaboratively with the private sector to explore 
opportunities for improving the payments system. The Committee 
has focused on several issues and has taken a market-oriented 
approach toward payment system innovation. As part of its 
efforts, the Committee and Federal Reserve staff are working 
with a number of standards-setting organizations to facilitate 
increased interoperability in the payments system.
    This Committee has also sought information from the private 
sector on other barriers to innovation and takes steps to 
address these barriers when appropriate. One such effort 
involves promoting the use of standard message formats when 
transmitting electronic files of check information for 
presentment. Another ongoing effort involves cooperation with 
banking industry and consumer representatives to determine how 
to address some of the legal impediments to the expanded use of 
truncation in check processing to reduce the cost of 
transporting and processing paper checks. Removing these 
impediments would require Congressional action.
    As noted earlier, the large-value U.S. payment systems 
cannot currently be accessed over the Internet. Security 
concerns and other technical issues, such as the inability to 
ensure service quality, limit the desirability of using the 
Internet for such systems. Most core clearing and settlement 
systems for retail payments similarly do not use the Internet 
for interbank clearing and settlement operations at this time.
    To conduct business over the Internet with the general 
public, many firms permit credit cards and some firms also 
permit automated clearing house transactions created from the 
information on a paper check (frequently referred to as a 
``electronic check'' or an ``e-check'') to be used to pay for 
goods and services ordered over the Internet. The various firms 
and clearing organizations involved in these transactions are 
experimenting with different arrangements for security and 
liability. At this stage, the Federal Reserve is continuing to 
monitor the rapidly changing developments in this area and to 
discuss these developments with the private sector. The Federal 
Reserve has not expressed public concerns about specific 
systems. To the extent payments are initiated through banks, 
bank supervisory policies pertaining to banking over the 
Internet would be relevant.

Q.11. Over the last decade, core deposits have declined as a 
percentage of bank and thrift assets, as individuals have taken 
advantage of new investment options. Declining deposits have 
forced banks to look elsewhere for sources of liquidity. Small 
community banks, which may have limited access to alternative 
funding sources, are increasingly relying on advances from the 
Federal Home Loan Banks as a way to meet their liquidity needs. 
Do you have any comments on this development and its 
implications, if any, for the financial services industry?

A.11. At smaller banks (those with assets less than $500 
million), the proportion of assets funded by FHLB advances rose 
from 3.8 percent to 6.3 percent between year-end 1995 and year-
end 2000. Larger banks showed a similar increase--from 3.4 
percent to 6.7 percent--suggesting that the banking system as a 
whole--and not just community banks--has been increasing its 
use of FHLB advances. This relatively limited usage by banks of 
FHLB advances to fund assets suggests that, to date, the 
subsidy provided by the FHLB's is not so substantial as to 
greatly limit banks' use of private sector sources of funding. 
With less than 15 percent of FHLB advances flowing to community 
banks, and with the use of advances by community banks being 
similar to that of larger institutions, neither the FHLB System 
nor the community banks appear, in general, to be uniquely 
dependent on each other. Of course, as I have noted in other 
forums, it is not clear that the FHLB System is either an 
efficient or cost effective way to subsidize housing or 
community development because the bulk of its subsidy goes to 
larger institutions and is not targeted toward the 
disadvantaged groups. It is appropriate that Congress 
occasionally review the role of FHLB's, just as it should 
periodically review all forms of subsidized credit and credit 
allocation mechanisms it has created, to determine if the role 
played by these organizations is still needed and justified.
Q.12. According to the Japanese banking industry's own publicly 
disclosed numbers, about 30 percent of bank assets are 
classified by examiners as having problems. Experience in the 
United States and other industrialized countries indicates that 
if a bank has classified assets of 10 percent to 15 percent of 
total assets, it is in danger of becoming insolvent and needs 
immediate supervisory action. The Finance Minister of Japan is 
reported to have said a few months ago that ``Japan's fiscal 
situation is at the verge of collapse.'' Data from various 
official and academic sources indicate Japan's government debt 
is well over 100 percent of GDP and growing rapidly, and some 
experts believe Japan is reaching its financing limits.
Q.12.a. What is your assessment of the Japanese banking system?
Q.12.b. What risk, if any, does the situation in Japan pose to 
both U.S. financial institutions and to the U.S. economy?
Q.12.c. What actions should be taken to improve it?

A.12.a. A combination of bad loans left over from the ``bubble 
economy'' and new bad loans from a weak economy have left 
Japanese banks with sizable asset quality problems. Sizable 
portfolios of problem loans suppress bank earnings, create 
uncertainty about bank asset values, and distract bank 
management from the business of making new loans.
A.12.b. U.S. banks and bank supervisory authorities are aware 
of the asset quality problems at Japanese banks and are alert 
to the risks they may pose. U.S. banks manage their exposures 
to Japanese banks with these risks in mind. In addition, U.S. 
bank supervisory authorities pay careful attention to the 
activities of the U.S. operations of Japanese banks.
A.12.c. A key step to improve the situation is to reduce the 
problem loans of Japanese banks. The Japanese government has 
recently announced a plan that aims to do so. In addition, the 
plan aims to lower the exposure of Japanese banks to swings in 
equity prices. This plan has the potential to improve the 
condition of the banks and hence, the soundness of Japanese 
financial system. How aggressively the plan is implemented will 
be critical in determining its success.

Q.13. There have been reports that Argentina is facing serious 
economic peril. What can you tell us on the situation in 
Argentina? What effect, if any, do you see on the U.S. economy 
as a whole, and specifically on the financial sector?

A.13. Argentina is in the midst of a recession that began in 
mid-1998. This prolonged downturn, in combination with 
traditionally poor tax collection, has generated shortfalls in 
fiscal revenues and contributed to the Federal government's 
sizable budget deficits. In addition, Argentina's external 
position is characterized by significant vulnerability, as the 
country has at times struggled to service its heavy external 
debt.
    In December 2000, as financial market anxiety about the 
outlook for Argentina's economy became acute, the country was 
granted a 3 year financial assistance package, including $14 
billion in loans from the IMF, as well as financing from 
various other official and private sources. To qualify for 
these funds, Argentina has been required to implement policies 
designed to strengthen its fiscal performance and stimulate 
growth. In addition, the Government has moved to reduce its 
debt-servicing burden in the short run with a $30 billion debt 
exchange, which was completed in early June. However, none of 
these efforts has proved sufficient to restore confidence among 
investors, and Argentine financial markets are currently 
experiencing a severe degree of pressure.
    U.S. trade with Argentina is minimal, accounting for less 
than 1 percent of our exports and imports. Accordingly, the 
direct impact through trade channels of disruptions in 
Argentina should be limited. On the financial side, the 
linkages are somewhat greater but, even so, the vulnerability 
of the U.S. financial system does not seem to be substantial. 
The exposure of U.S. institutions to Argentina is small 
relative to their combined capital. Argentina is a sizable 
presence in the market for developing-country debt, but the 
prolonged nature of Argentina's economic problems has 
presumably allowed investors time to adjust their portfolios in 
response to the increasing level of risk. However, other 
emerging market economies are experiencing some spillover 
effects. The managing director of the IMF has announced a 
proposed extension of Brazil's support program to strengthen 
Brazil's financial resources.

Q.14. In a speech before the American Bankers Association, 
Federal Reserve Board of Governors Member Edward Gramlich said 
that, ``Higher rates of national savings are among the unsung 
heroes of the good U.S. economic performance in the late 
1990's.'' However, the most recent data from the White House 
shows a substantial decline in personal savings, from over 5 
percent in 1996 to minus 0.9 percent today. Do you think that 
this is a serious problem, and if so, what can we do to 
ameliorate it? What position does this place Americans in if 
the economic slowdown worsens? Finally, what are the effects of 
this decline with respect to national investment levels and GDP 
growth?

A.14. The general decline in the personal saving rate over the 
past two decades has been a source of concern for policymakers. 
The recent precipitous decline of the personal saving rate into 
negative territory has heightened these concerns but needs to 
be evaluated with respect to other developments in households' 
financial situations. While personal saving as a percentage of 
personal disposable income declined from 1996 to today, 
households' net worth--measured in the Federal Reserve Board's 
Flow of Fund accounts--rose from about five times personal 
disposable income at the beginning of 1996 to more than five 
and a half times personal disposable income today. Households 
have reacted to this increase in wealth by boosting their 
spending relative to their current income. Because saving is 
measured in the national income accounts as the difference 
between current income (not including capital gains) and 
spending, the additional spending supported by wealth increases 
has resulted in lower measured personal saving. That said, 
there are still valid concerns about whether households are 
saving enough to help fund investment in the economy, and 
whether households are adequately prepared for retirement.
    Recent research by economists at the Federal Reserve Board 
using data from our Flow of Funds Accounts and Surveys of 
Consumer Finances suggests that the latest decline in personal 
saving rates is primarily a consequence of a plummeting saving 
rate for high-income households, which are generally the type 
of households most able to weather an economic slowdown. Lower-
income households are generally more susceptible to problems 
during less robust economic times, but these are not the 
households whose saving rates have been declining in recent 
years. While it is certainly appropriate for policymakers to be 
concerned about the financial situations of households during 
an economic slowdown, the personal saving rate is not 
necessarily the best indicator of potential trouble.
    The level of investment in the U.S. economy has played a 
very important part in increasing productivity and real GDP 
growth in recent years. As Governor Gramlich indicated in his 
recent speech before the American Bankers Association, national 
saving is an important determinant of national investment. 
National saving comprises personal saving, business saving, and 
Government saving, and thus a decline in personal saving would 
lead to a decrease in national saving if all other sources of 
saving remained the same. In recent years national saving has 
been rising primarily because the increase in Government saving 
and, to a lesser degree, the increase in business saving have 
more than offset the decline in personal saving. Moreover, 
these divergent trends are not necessarily unrelated. For 
example, strong corporate profits bolstered business saving and 
helped spur the significant capital gains in corporate stocks. 
Tax payments on realized capital gains boosted Government 
saving while at the same time contributing to the decline in 
personal saving. Thus, all sources of saving must be considered 
when looking at the funds available for investment.

Q.15.a. What forms, if any, of bank surveillance are done 
through automated technology and/or the Internet?
Q.15.b. Does your agency have any plans to augment the role of 
automated technology in gathering and disseminating 
information?

A.15.a. To supplement on-site examination activities, the 
Federal Reserve routinely monitors the financial condition and 
performance of banks and bank holding companies using automated 
screening systems. These surveillance systems utilize financial 
data reported on quarterly regulatory reports and focus heavily 
on identifying banking organizations that are exhibiting 
problems or deteriorating so that examination resources can be 
directed to troubled companies. Further, surveillance screens 
are used to flag companies engaged in new or complex activities 
to assist examiners in planning on-site examinations. 
Currently, specialized surveillance programs are run quarterly 
for State member banks, small shell bank holding companies, and 
the remaining larger and more complex banking holding 
companies. The Federal Reserve also uses an automated screening 
system to monitor compliance by financial holding companies 
with the requirements of the Gramm-Leach-Bliley Act.
    In addition, the Federal Reserve utilizes an automated 
system to produce Uniform Bank Holding Company Performance 
Reports, which include detailed current and historical 
financial and peer group information for individual banking 
organizations. These reports are primary analytical tools for 
examiners and are also provided to management at bank holding 
companies. With the exception of a small number of confidential 
items, these reports are also made available to the public. 
Recent surveillance initiatives have focused on achieving 
timely electronic delivery of surveillance information. For 
example, the Federal Reserve has included a number of 
surveillance notifications in its Banking Organization National 
Desktop (BOND) application. These notifications push screening 
results and data directly to the e-mailbox of analysts and 
examiners responsible for supervising complex banking 
organizations. The Federal Reserve also maintains other 
computer applications that facilitate access to financial data 
from regulatory reports and to surveillance program results for 
all banks and BHC's. For instance, using the Performance Report 
Information and Surveillance Monitoring (PRISM) application, 
examiners and analysts can readily access the Board's extensive 
database of financial and surveillance data and perform 
customized analyses of trends and developments at supervised 
institutions. Examiners and supervisory staff can also generate 
electronic reports that summarize surveillance program results 
for individual banking organizations.
A.15.b. Regarding the augmentation of the role of technology in 
the gathering of information, beginning in September 2001 the 
Federal Reserve will implement a web based system that will 
allow financial and bank holding companies to file their FR 
Y10-Report of Changes in Organizational Structure via the 
Internet. This system will assist the institutions in the 
completion of the form and will allow them to provide the data 
electronically. On a trial basis, the system is being made 
available to a small set of holding companies in September and, 
gradually, the population of holding companies will be expanded 
over the coming months. Approximately 6 months later, we plan 
to expand the population further to include foreign banking 
organizations that operate in the United States and are 
required to file the FR Y10f. We hope to expand this capability 
to other regulatory reports in the near future. We have also 
established a capability to receive automated downloads of loan 
data from State member banks to assist in the preparation of 
examinations, and we receive shared national credit data 
electronically from respondent institutions. Last, we 
participate with the FFIEC agencies in the automated collection 
of Call Reports and HMDA and CRA data from banks. We are 
working with the FFIEC Reports Task Force to examine the 
possibility of using Extensible Markup Language (XML) as an 
alternative for the Call Report and potentially other 
regulatory reports in the future.
    Regarding further automation in the dissemination of 
information, the Federal Reserve places much of its publicly 
available regulatory information on the Board of Governor's web 
site (www.federalreserve.gov). The public can also access 
several educational and training tools, as well as studies and 
reports related to community and economic development. We 
disseminate public regulatory report information through our 
National Information Center web site (www.ffiec.gov/nic), and 
HMDA and CRA information, data, and reports through the FFIEC 
HMDA (www.ffiec.gov/hmd) and CRA (www.ffiec.gov/cra) web sites. 
In addition, through the FFIEC web site (www.ffiec.gov/info-
services.htm), we provide access to a mapping tool, geocoding 
tool, and the census data that the FFIEC uses to create HMDA 
and CRA reports.

   RESPONSE TO WRITTEN QUESTIONS OF SENATOR ENSIGN FROM ALAN 
                           GREENSPAN

Q.1. What is your insight regarding the status of the pending 
regulation by the Federal Reserve Board and the Treasury 
Department that would redefine real estate brokerage and 
management as financial activities?

A.1. The Board received more than 46,000 comments from the 
public in response to the invitation by the Board and the 
Secretary of the Treasury for comment on whether real estate 
brokerage and management activities are financial in nature or 
incidental to a financial activity. We believe that it is 
important to consider the public comments and other relevant 
information carefully.
    The Staff of the Board and the Treasury Department are in 
the process of reviewing and analyzing the information that the 
public has provided. Because of the volume of comments and 
information provided, that process will take some time.

Q.2 What are your views regarding the impact the proposed rule 
could have on the real estate brokerage industry and the 
financial services industry?

A.2. I do not have any firm views regarding the appropriate 
resolution of the proposal or the impact that various outcomes 
might have on the real estate industry or the financial 
services industry. The Board will consider these matters, along 
with the other standards enumerated in the Gramm-Leach-Bliley 
Act, as part of its review of the comments and the proposal.

Q.3. Real estate brokerage was not specifically addressed in 
the Gramm-Leach-Bliley legislation that was enacted into law at 
the end of the 106th Congress. Can you discuss your views of 
the Congressional intent of Gramm-Leach-Bliley regarding real 
estate brokerage's definition as a financial activity?

A.3. The Gramm-Leach-Bliley Act expanded the authority of 
companies that qualify as financial holding companies to engage 
in new activities and affiliate with other companies. The Act 
specifically listed a number of activities that Congress 
determined to be financial in nature and, therefore, 
permissible by statute for FHC's and their affiliates to 
conduct. These activities include broad securities underwriting 
activities, insurance underwriting and agency activities, 
merchant banking activities, activities previously determined 
by the Board to be closely related to banking, and activities 
that the Board has previously found by rule to be usual in 
connection with the conduct of banking abroad.
    In addition to this list of specific activities, Congress 
specifically included in the Gramm-Leach-Bliley Act a provision 
that allows financial holding companies to engage in any 
activity that the Board, in consultation with the Secretary of 
the Treasury, determines to be ``financial in nature or 
incidental to a financial activity.'' This provision was 
included in order to grant the Board and the Secretary 
flexibility to address and permit activities that were not 
addressed by Congress.
    In determining whether an activity is financial in nature 
or incidental to a financial activity, the Act requires the 
Board and the Secretary to consider a number of factors 
including whether the activity is necessary or appropriate to 
allow a financial holding company ``to compete effectively with 
any company seeking to provide financial services in the United 
States.'' In addition, the Act requires the Board and the 
Secretary to consider the purposes of the Bank Holding Company 
Act and the Gramm-Leach-Bliley Act, changes or reasonably 
expected changes in the marketplace in which financial holding 
companies compete and in the technology for delivering 
financial services, as well as other factors. While Congress 
included a provision allowing the agencies flexibility in 
defining permissible activities, Congress determined not to 
include a provision in the Gramm-Leach-Bliley Act that would 
have allowed the general mixing of banking and commerce within 
financial holding companies. At the heart of the debate 
regarding real estate brokerage activities is the question 
whether real estate brokerage activities involve activities 
that are financial in nature or commercial in nature. The 
commenters focus on this issue and the Board will carefully 
consider this matter as it reviews the comments and consults 
with the Secretary of the Treasury.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES FROM JOHN D. 
                           HAWKE JR.

Q.1. What do you think is the greatest potential problem facing 
the U.S. financial system today?

A.1. The main issues are credit risk and liquidity risk. The 
costs of managing these risks will likely cause earnings to 
decline in future quarters. The degree of the decline is 
contingent on the length and depth of the economic slowdown in 
the United States and overseas. The slowdown in the 
manufacturing sector is causing deterioration in asset quality 
not only in the large banks' commercial & industrial (C&I) loan 
category but also for C&I loans in some smaller banks across 
the country.
    Banks also are reporting a steady decline in their deposit 
base resulting in increasing liquidity risk. The decline can be 
attributed in part to the strong gains in the equity markets in 
the 1990's, which has encouraged households to move their funds 
to higher yielding assets. For banks, this means that they must 
seek alternative sources of funding, which can be more rate and 
market sensitive. Managing the more rate-sensitive and 
potentially volatile sources of funding is a challenge for both 
large and small banks.

Q.2. While many analysts predict a recovery from the current 
economic slowdown in the second half of the year, there is 
still a chance that the downturn could be worse than expected. 
If the economy were to perform below expectations, what 
consequences would that have for the safety and the soundness 
of the banking system?
    Specifically, I would like to ask about the banking 
system's risk exposure in the following areas:

 Noncurrent Loans
 Credit Card and Consumer Loans
 Mortgage Delinquencies
 Telecommunications Sector

A.2. Bank earnings will remain under pressure if the slowdown 
in economic growth continues. Noncurrent loans in the banking 
system are expected to increase for at least the remainder of 
2001. If the banking system is subjected to long-term and deep 
economic weaknesses, some bank failures may occur. As I noted 
in my testimony, the national banking system is in a stronger 
position today to bear the stresses of an economic slowdown 
than a decade ago--it is better capitalized, earnings are 
stronger, bank balance sheets and revenue streams are generally 
more diversified, banks' risk-management systems have improved, 
and the asset quality of the national banking system is 
certainly better.
    Even with their profitability under pressure, banks 
strengthened their capital ratios over the last year. The level 
of capital in the national banking system remains at a 
historical high and provides an additional cushion against 
unexpected losses--the risk-based capital ratio was 12.1 
percent at the end of first quarter 2001, compared to 9.0 
percent at the end of first quarter 1990. Moreover, the portion 
of the banking industry facing the economic slowdown from a 
position of weak performance is substantially less than a 
decade ago. Nearly 98 percent of all national banks met the 
regulatory definition of well-capitalized by maintaining a 
ratio of equity capital to assets above 5 percent and a total 
capital to risk-based assets ratio above 10 percent.
    The bulleted topics of this question are addressed 
separately in the responses to questions 3 through 6.

Q.3. After 5 very good years, the rate of nonperforming 
commercial, industrial, and personal loans increased by 26.5 
percent in 2000. Can you please tell me what stress, if any, 
this places on the banking system and whether or not you expect 
a similar rate of increase for this current year?

A.3. The deterioration in asset quality has affected bank 
earnings through higher loan loss provisioning to increase loan 
loss reserves. While the coverage ratio of loss reserves to 
noncurrent loans declined at the end of first quarter 2001 to 
its lowest level since 1993, it still remains high at 138 
percent and well exceeds the 68 percent coverage level at year 
end 1990. As noted above, the national banking system remains 
well capitalized, and even with their profitability under 
pressure, banks strengthened their capital ratios over the last 
year.
    There are signs of increasing credit risk in the banking 
system, as the financial positions of some businesses and 
households are weakening due to slow economic growth. The 
greatest deterioration in credit quality has been in the 
Commercial & Industrial (C&I) loans category. The noncurrent 
C&I loan ratio rose by 22 basis points from 1.66 percent at 
year end 2000 to 1.88 percent at the end of first quarter 2001. 
While the deterioration has been more pronounced for large 
national banks, there were signs it has begun to spread to 
smaller banks. The concentration of the problem in business 
lending tracks developments in the overall economy with 
corporate profits declining and bond default rates rising. 
Therefore, banks' C&I loan quality is expected to continue to 
deteriorate if the economy continues to weaken.

Q.4. Though the delinquency rates for credit cards and consumer 
loans are well below the levels experienced during the last 
economic slowdown, they have risen back to levels comparable to 
1993. What do you think the effects of this increase in 
delinquency rates will be, with regard to both consumers and 
the financial institutions you regulate?

A.4. Consumer lending remains a concern given the high consumer 
debt levels and the potential reliance of the consumer on more 
variable sources of income to service that debt. Consumers' 
indebtedness today relative to their income is at an all time 
high. If there is a prolonged slowdown and localized areas see 
sharp increases in layoffs, consumer defaults on loans may 
increase. As a result, banks may experience rising noncurrent 
ratios and charge-offs.

Q.5. According to a Mortgage Bankers Association survey, 10 
percent of mortgages backed by the Federal Housing 
Administration are now 30 or more days delinquent. An article 
in the June 12 New York Times stated, ``The mortgage problems 
underscore one main reason many policymakers and economists are 
so concerned about whether the United States will enter a 
recession this year.'' Can you please tell the Committee your 
thoughts and concerns about the high level of mortgage 
delinquency?

A.5. The national banking system had $457.3 billion of loans 
secured by 1-4 family residential mortgages as of the end of 
first quarter 2001. These accounted for 20.3 percent of total 
national bank loans, and included a wide variety of residential 
mortgage loans, including FHA loans. The noncurrent loan ratio 
for loans secured by 1 to 4 family residential mortgages in the 
national banking system has remained less than 1.2 percent 
since year end 1994. This level of delinquency is manageable 
relative to banks' capital and loan allowances. The ratio of 
charge-offs for 1 to 4 family residential mortgages was 0.14 
percent at the end of first quarter 2001, and for the last 10 
years has remained under the .27 percent peak experienced in 
1992. The housing market has been fairly resilient to the most 
recent economic developments, but is vulnerable to a more 
protracted slowdown.

Q.6. I have heard from varying persons that the banking 
industry has significant exposure in the telecommunications 
sector. What is the direct and indirect exposure to the fallout 
in the telecommunications sector?

A.6. The primary source of data for industry exposures is the 
Shared National Credit \1\ (SNC) data. The processing of the 
SNC data for 2001 is still underway, but preliminary data 
indicate telecom commitments of $130 billion with outstandings 
of $49 billion. Because many nonbanks banks (that is loan 
funds, insurance companies, and mutual funds) hold the majority 
of the lower tranches of these credits, the exposure to the 
banking industry will be significantly lower than the reported 
SNC totals. By the same token, banks have direct and indirect 
exposure to the telecommunications industry that are not 
captured in the SNC data.
---------------------------------------------------------------------------
    \1\ Shared national credits are loans extended to a borrower of $20 
million or greater that are shared by three or more unaffiliated, 
supervised institutions. They are reviewed annually in May and June by 
teams of interagency examiners.
---------------------------------------------------------------------------
    Telecommunication credits are primarily held by a few of 
the largest banks, but they generally do not constitute 
significant concentrations for these institutions. These 
institutions typically have appropriate risk-management 
processes and reserving methodologies. Their problem loan 
identification has improved in the past year and their loan 
loss provisions have kept pace with charge-offs.

Q.7. According to the OCC, consumers are more highly leveraged 
now than at any measured point in history. Not only are debt 
service payments at historical highs, but also the increase in 
debt has been financed through instruments other than 
mortgages. Credit card debt is rising very rapidly; the Chicago 
Sun-Times reported that the average credit card debt per 
household is $8,123 and has grown threefold over the past 
decade. Debt service payments constitute over 14 percent of 
disposable income. What do you believe the effects of this high 
level of personal debt will be with regard to consumers, the 
banking sector, and the economy as a whole. If the economic 
downturn is worse than expected, what would be the effect of 
having many people so highly leveraged?

A.7. Although the credit quality of loans to individuals has 
generally not shown signs of stress comparable to that for 
business lending, pressure is also increasing on the consumer. 
During the period 1986 to 1992, consumer debt obligations 
declined because of the refinancing boom that enabled consumers 
to pay down some of their higher cost debt with income 
available from refinancing. Today, both mortgage debt and other 
consumer debt are rising. Despite the refinancing boom over the 
last 6 months, some consumers have reloaded their credit card 
and installment debt. These individuals will have a difficult 
time servicing their higher debt levels if they are faced with 
adverse circumstances such as rising energy costs, or less 
favorable income levels in the event of job changes, and/or 
layoffs in a slowing economy.
    The recent sharp increases in personal bankruptcies are in 
part linked to high consumer debt burdens coupled with a 
slowing economy. Many analysts project bankruptcy filings to 
continue to be high throughout 2001. The volume of personal 
bankruptcies has a direct impact on the level of losses in 
consumer loan portfolios, particularly for unsecured loans. In 
this environment, some banks' credit card portfolios are 
experiencing higher loss rates, though they remain within 
historical norms. While bank losses for consumer loans remain 
modest, if there is a prolonged slowdown and localized areas 
experience layoffs, rising levels of noncurrent loans and 
increased charge-offs related to banks' consumer portfolios are 
likely. Overall, while the performance trends of consumer 
portfolios recently turned negative, the quality of consumer 
loans in the national banking system remains relatively stable.

Q.8. Remittances are a large and growing economic reality that 
affect millions of people both in America and south of the 
border. It has recently come to my attention that this 
industry, which recent estimates have put at more than $20 
billion annually, often charges high fees and that many of the 
leading companies have been challenged in court for having 
hidden fees. In a New York Times article it is stated that 
``the fees have run from about 10 percent to 25 percent or 
more.'' Do you believe that there are problems in the manner in 
which the bulk of remittances are made today? What steps has 
your agency taken to analyze possible solutions including 
fostering or creating alternative transfer mechanisms?

A.8. Remittance services are often provided without complete 
information on the total costs incurred for the service. The 
total costs for international remittances may include both 
explicit fees, as well as an exchange rate for the foreign 
local currency that is disbursed from the amount sent in U.S. 
dollars. This exchange rate may not be favorable relative to 
market rates, and is often not explicitly disclosed to the 
customer.
    The OCC recognizes the importance of this issue, as well as 
the many questions that would need to be answered before an 
effective policy response could be developed. The agency would 
welcome the opportunity to work with other Federal bank 
regulatory agencies to discuss possible solutions.

Q.9. Former Treasury Secretary Summers has stated that ``all 
high school students should receive a financial education'' and 
that ``though personal financial education must begin in the 
home, it must continue in the schools.'' Can you please comment 
on the state of financial literacy and education among 
Americans, including any deficiency in this area that should be 
addressed? If you see any deficiencies, what do you believe can 
and should be done with regard to these deficiencies in both a 
broad sense and with regard to your agency? At the hearing I 
asked for information regarding any initiatives that your 
agency has taken, including the Money Smart program. Could you 
please provide this information in your submission to the 
record?

A.9. While most individuals continue to enjoy the benefits of 
the longest period of sustained economic growth in the United 
States, a sizable portion of the U.S. population remains on the 
fringes of the banking system. According to the 1998 Survey of 
Consumer Finances published by the Federal Reserve Board, 10 
percent of U.S. households do not have a depository account 
with a financial institution. Additionally, the number of 
check-cashing stores continues to rise, while the national 
savings rate has fallen to the lowest level in recent history. 
Concerns regarding abusive lending practices also indicate a 
need for consumer education.
    Recent surveys suggest that financial literacy is low among 
the American population as a whole, and especially low among 
young people. A 2000 survey conducted by the JumpStart 
Coalition for Personal Financial Literacy found that most high 
school seniors failed a test of basic financial subjects 
involving questions on banking products, credit cards, taxes, 
savings, and investments.
    In order to encourage bank participation in financial 
literacy initiatives, the OCC issued an Advisory Letter AL 
2001-1 on January 16, 2001 (available on the OCC website at 
www.occ.treas.gov/issuances). This guidance provides national 
banks with information on the types of financial literacy 
programs that have been undertaken by banks and aspects of 
those programs that have been most important to their success. 
Released in conjunction with the advisory letter, the OCC 
maintains a resource directory available on the OCC website at 
www.occ.treas.gov/cdd/commfoc.htm that provides information 
about programs and initiatives that span the lifecycle from 
youth to retirement and illustrate the categories of financial 
literacy activities described in the advisory.
    Also, the OCC is one of only four Federal agencies to have 
entered into a partnership with the National Academy 
Foundation, a nonprofit organization dedicated to supporting 
the development of the country's young people toward personal 
and professional success. Our partnership with NAF has centered 
on its Academy of Finance, which aims to promote financial 
literacy among high school students and helps to prepare those 
students for further education and careers in the financial 
services field. Most recently, OCC staff have undertaken a 
comprehensive revision of the Academy's course in Banking and 
Credit, to ensure that the material being taught to students in 
the NAF program is accurate and up-to-date.
    The banking agencies recognize the impact of financial 
literacy programs through the Community Reinvestment Act. Bank 
participation in financial literacy programs that target both 
low- and moderate-income individuals can be structured to 
receive positive 
consideration under the lending, investment, and service tests 
of the Community Reinvestment Act.
    The Money Smart program mentioned in the question is a 
joint initiative of the FDIC and the Department of Labor. The 
Money Smart program provides a comprehensive adult financial 
education curriculum at centers nationwide that offer 
employment and training services. Banks and other institutions 
can also use this curriculum to serve their communities. This 
type of initiative supports the goals of expanding financial 
education for consumers.

Q.10. What steps has the Federal Reserve taken to promote 
technology and innovation in the payments system, and what 
steps should it take? As well, are you concerned that the 
initiation of payments on the Internet, or through other 
electronic means, could affect the safe operation of the 
payments system? Note that the first part of this question is 
directed at the Federal Reserve System, thus the OCC response 
will speak only to the bolded section of the question.

A.10. OCC as supervisor for national banks examines those risks 
associated with national bank participation in the payments 
system, and takes actions as appropriate to ensure that banks 
conduct these activities in a safe and sound manner. The OCC is 
concerned about some specific issues that relate to Internet 
payments. One such issue is authentication. Confirming the 
identity of customers online is an issue with which the 
financial services industry is struggling. The OCC participated 
in a FFIEC Symposium on this topic in March, and will 
participate in the development of FFIEC guidance on electronic 
authentication.
    In addition, the OCC recently issued guidance to national 
banks on complying with the new rules issued by the National 
Automated Clearing House Association (NACHA) on certain 
Internet-initiated automated clearing house payments. These 
important new rules are designed to reduce fraud by increasing 
the responsibilities of companies that enable customers to 
direct Internet payments through the Automated Clearing House 
(ACH) network. The OCC issued Advisory Letter 2001-3 in January 
to alert national banks to this rule change and will soon issue 
examination procedures.
    The OCC is seeking to eliminate some of the uncertainty for 
national banks that exists in electronic banking activities, 
including payments. On a case-by-case basis, the OCC has 
authorized a number of activities in national banks including 
electronic bill payment and presentment and online merchant 
processing of credit card transactions. (These and other 
related decisions are posted on the OCC website 
www.occ.treas.gov). To further codify these and other positions 
that OCC has taken with regard to electronic banking, on July 
3, 2001 the OCC published a proposed rule that would provide 
simpler and clearer guidance for electronic and developing 
technologies activities www.occ.treas.gov/01rellst.htm.

Q.11. Comptroller Hawke, at a speech you gave on December 2, 
1999, you talked about privacy and consumers' interest in 
controlling the sharing of their personal confidential 
financial data with other companies for unintended purposes. 
You said, ``The industry's argument was that to allow customers 
to prevent banks from sharing confidential customer information 
with their affiliates would destroy the synergies and 
efficiencies that would be made possible by the new law. I do 
not accept this argument . . .'' It should not be assumed that 
customers will automatically opt out. If banks and other 
financial firms really have something to offer customers, they 
should be able to convince them not to opt out--that 
information sharing is really in their interest, if that is in 
fact the case. There is a certain patronizing quality in the 
argument that we should not allow customers to opt out because 
we really know what is best for them. Do you feel the synergies 
from the Gramm-Leach-Bliley Act can coexist with allowing 
customers to control the sharing of their information with 
affiliates?

A.11. Consumers already possess the ability to direct financial 
institutions not to share certain confidential information 
about them with affiliates under the Fair Credit Reporting Act. 
This opt out right pertains to consumer reporting information, 
such as application information that relates to a consumer's 
creditworthiness. There is no current evidence that this opt 
out right has harmed the business opportunities among 
affiliated financial institutions. Of course, affiliated 
companies must remain free to disclose customer information to 
one another in order to service or process a transaction that a 
consumer initiates. This type of information disclosure is 
consistent with that permitted between nonaffiliated third 
parties under the Gramm-Leach-Bliley Act (GLBA). Providing 
consumers with the ability to opt out of information 
disclosures among affiliated companies for marketing, however, 
would not appear to destroy potential synergies among the 
companies. Based on the rate of opt outs under both the FCRA 
and the GLBA, thus far, an assumption that customers will 
automatically opt out of affiliate information sharing would 
appear to be erroneous.

Q.12. On September 16, 1997, a Subcommittee of the Senate 
Banking Committee, chaired by Senator Bennett, held an 
important hearing on the issue of identity theft, which occurs 
when someone uses the personal information of another person to 
obtain credit cards or other financial instruments or assets. 
Just a few weeks ago, The Washington Post published an article 
by Robert O'Harrow which observed that ``the Justice Department 
says that `identity theft is one of the Nation's fastest 
growing white-collar crimes.' '' How prevalent is this crime? 
What is its impact on bank customers and on banks? What efforts 
are being taken to end this practice?

A.12. The OCC does not have independent statistics about the 
prevalence of identity theft. However, there has been a 
significant increase in the incidence of identity theft 
reported in Suspicious Activity Reports (SAR's). SAR statistics 
compiled by FinCEN indicate that the number of reported 
incidents of identity theft increased from 44 in 1997 to 617 in 
the first 11 months of 2000. There are 1,030 SAR's in the 
system reporting identity theft and this number is likely to 
grow, especially in light of a recent OCC advisory letter to 
national banks on identity theft and pretext calling, that 
instructed banks specifically how to report incidents of 
suspected identity theft and pretext calling on a SAR.
    This year, the OCC's Consumer Assistance Group received 105 
complaints involving identity theft. Seventy-eight complaints 
involved credit card accounts and 27 related to checking 
accounts. However, the FTC's identity theft hotline receives 
thousands of calls each week. Half of the complaints the FTC 
has been receiving involve credit card fraud. Figures are not 
available with respect to losses to banks or their customers as 
a result of identity theft. However, identity theft does result 
in monetary losses to both bank customers and the institutions 
themselves. Under Regulation Z, in instances involving identity 
theft, a consumer could incur liability for the unauthorized 
use of the consumer's credit card account up to $50. The card 
issuer is responsible for the remaining losses to the consumer. 
Under Regulation E, a consumer's liability for unauthorized 
electronic fund transfers involving his or her account varies 
depending upon the precise circumstances of the unauthorized 
use and the consumer's timeliness in reporting unauthorized 
transactions or the loss or theft of an access card, number, or 
other 
device. Where a consumer acts promptly upon discovering an 
unauthorized transaction, in most circumstances the bank will 
be responsible for the total amount of any such transaction.
    As mentioned above, in April, the OCC issued Advisory 
Letter 2001-4 to increase banks' awareness in regards to 
identity theft and pretext calling and encourage banks to take 
specific measures to protect their customers against these 
types of fraud. The letter informs banks about safeguards to 
prevent identity theft--such as verification procedures for new 
customer accounts, verification of change of address requests, 
and implementation of the new interagency security standards. 
The advisory letter also encourages banks to educate their 
customers about ways to prevent identity theft and pretext 
calling and to assist those customers who may have been the 
victims of such fraud. The advisory directs banks to a consumer 
brochure on the OCC's website (www.occ.treas.gov/idtheft.pdf) 
on identity theft and pretext calling that banks may download 
and provide to their customers.

Q.13.a. According to the Japanese banking industry's own 
publicly disclosed numbers, about 30 percent of bank assets are 
classified by examiners as having problems. Experience in the 
United States and other industrialized countries indicates that 
if a bank has classified assets of 10 percent to 15 percent of 
total assets, it is in danger of becoming insolvent and needs 
immediate supervisory action. The Finance Minister of Japan is 
reported to have said a few months ago that ``Japan's fiscal 
situation is at the verge of collapse.'' Data from various 
official and academic sources indicate Japan's government debt 
is well over 100 percent of GDP and growing rapidly, and some 
experts believe Japan is reaching its financing limits. What is 
your assessment of the Japanese banking system?

A.13.a. The Japanese banking system remains in poor condition. 
While the infusion of public money relieved some of the 
pressure from the 1998 crisis and reduced systemic risk, the 
resolution of bad assets has not been completed. In general, 
banks' earnings are weak. As domestic and global economic 
conditions slow, the health of the banking sector may worsen. 
Additionally, the decline in Japan's stock markets combined 
with the application of more stringent mark-to-market 
accounting standards limits the banks' gains from sizable 
equity holdings, which have been a recurring source of 
significant income in the past.

Q.13.b. What risk, if any, does the situation in Japan pose to 
both U.S. financial institutions and to the U.S. economy?

A.13.b. Japan holds among the largest foreign exchange reserves 
in the world thereby mitigating transfer risks to U.S. 
financial institutions. But over the past decade of Japan's 
economic stagnation, U.S. financial institutions have been 
subject to increased credit risks on Japanese exposures. As a 
result, U.S. banks have reduced their Japan exposures from the 
peak of $103.5 billion at year end 1998 to $83.8 billion at 
year end 2000. About 54 percent of Japanese exposures are 
cross-border claims while the rest are booked in the Japanese 
offices of U.S. banks.
    Japan's economy is important to the United States and 
global economies and financial markets. For many Southeast 
Asian countries, Japan is a major export market, investor, and, 
in certain industries, a competitor. Continued economic 
weakness in Japan can be expected to reduce growth and put 
downward pressure on currencies throughout Southeast Asia. 
Potential effects on the U.S. economy are not expected to be 
severe. But Japan is the third biggest market for U.S. exports 
and a major source of investment in U.S. markets, so the 
effects will be a factor for the U.S. economic markets. If 
Japan faces a liquidity crisis due to financial system 
weaknesses, Japanese investors may turn to their investments in 
the United States as a source of funds. Taken together, 
financial turmoil in Japan has the possibility of increasing 
volatility in U.S. debt and equity markets. The OCC maintains 
ongoing contact with Japanese bank supervisors, including 
periodic meetings with senior officials of the Financial 
Services Agency to regularly assess these potential 
developments.

Q.13.c. What actions should be taken to improve it?

A.13.c. Japan's economic and financial sector problems are deep 
rooted and require a comprehensive approach on a variety of 
fronts. Recently, the government outlined a series of steps, 
with one high priority the resolution of the bad loan problem. 
Effective follow-through on the stated priorities is essential 
to the recovery of the Japanese economy.
    In recent years, the Japanese authorities have made 
progress in improving bank supervision. They established the 
Financial Services Agency (FSA) as the key financial services 
regulator, and they are building a more risk-focused 
supervisory function. U.S. regulatory agencies will continue to 
work with the FSA staff to promote a more effective global 
supervisory process.

Q.14. There have been reports that Argentina is facing serious 
economic peril. What can you tell us on the situation in 
Argentina? What effect, if any, do you see on the United 
States' economy as a whole, and specifically on the financial 
sector?

A.14. The Argentine government remains in a difficult situation 
as it tries to revitalize its economy. Argentina has been mired 
in a domestic confidence problem, which has slowed tax revenues 
causing the government's fiscal deficit to escalate and 
investors to question whether the government could meet its 
debt payments. This concern is resurfacing, despite a 
restructuring of a significant amount of debt, as high-interest 
rates compound Argentina's debt servicing requirements.
    U.S. national bank exposure is within reasonable bounds. 
Naturally, U.S. banks may experience some credit problems with 
their exposures, but U.S. banks generally have had sufficient 
time to position themselves to limit the effects from a full-
fledged crisis. With respect to the U.S. economy overall, 
Argentina's recession and turbulence have not affected the 
United States to any significant degree as trade with Argentina 
is less than 1 percent of U.S. exports. The OCC continues to 
closely monitor developments in Argentina, as well as contagion 
and spill over effects, and the implications for the national 
banking system.

Q.15. Another disparity involves rules on loans to one 
borrower. National banks are generally allowed to lend no more 
than 15 percent of their capital on an unsecured basis to a 
single borrower. Many States have higher limits for the banks 
they charter. On June 8, 2001, the OCC announced a new pilot 
program allowing national banks with the highest supervisory 
rating to lend up to the State limit--but no more than 25 
percent of capital--to single borrowers under certain 
circumstances. Please describe the competitive regulatory 
disparity that led the OCC to implement this pilot program.

A.15. As a routine and ongoing part of our supervisory 
activities, representatives of the OCC conduct outreach 
meetings with bankers in various settings across the country. 
During these meetings, bankers in States with higher legal 
lending limits indicate that this disparity in the amount of 
credit they are permitted to advance to one borrower puts them 
at a competitive disadvantage with State chartered banks. This 
is because they are not able to provide the level of services 
to some of their best customers that similar size State banks 
can provide. It is also viewed by many banks as a burden issue 
because if they want to make such loans they must find other 
banks to participate if they are to retain the lending 
relationship. Bankers also view this as a loss of potential 
loan income at a time when earnings trends are declining.
    There are 25 States that have a lending limit for unsecured 
loans that is higher than the national bank lending limits. 
This pilot program allows eligible banks in those States with 
higher lending limits to make loans up to the State limits for 
residential loans secured by real estate and for unsecured 
small business loans. This program is only available to 
eligible banks, for example, they must be rated at least a 
composite ``2,'' the management and asset quality components 
must be rated ``1'' or ``2,'' and their participation is also 
subject to approval by their supervisory office. Also, at the 
discretion of the supervisory office, their authority under 
this program may be withdrawn at any time.

Q.16. In a speech before the American Bankers Association, 
Federal Reserve Board of Governors Member Edward Gramlich said 
that, ``Higher rates of national savings are among the unsung 
heroes of good U.S. economic performance in the late 1990's.'' 
But the most recent data from the White House shows a 
substantial decline in personal savings, from over 5 percent in 
1996 to minus 0.9 percent today. Do you think that this is a 
serious problem, and if so, what can we do to ameliorate it? 
What position does this place Americans in if the economic 
slowdown worsens? What are the effects of this decline with 
respect to national investment levels and GDP growth?

A.16. The drop in the reported personal savings rate over the 
last 5 years from 5 percent to 0.9 percent provides a distorted 
measure of household finances and households' ability to 
continue spending. The reported savings rate as calculated from 
the National Income and Product Accounts (NIPA) is calculated 
as disposable personal income less personal outlays, as a 
percent of disposable income. The NIPA disposable income 
measure, however, understates household resources available for 
spending because it focuses on production and does not include 
realized or unrealized gains or losses from the sale of 
nonproduced assets, such as land or financial assets (stocks 
and bonds). Researchers at the Federal Reserve Bank of New York 
\2\ have constructed a more meaningful measure of personal 
savings including capital gains. The results of their study 
indicate that the personal savings rate and the resources 
available to households for spending have not declined over the 
last 5 years. Thus, the reported personal savings rate may not 
fully reflect the financial position of households, and may 
mask the true increase in national savings referred to by 
Federal Reserve Board Governor Gramlich.
---------------------------------------------------------------------------
    \2\ Peach, Richard, and Charles Steindel. ``A Nation of 
Spendthrifts? An Analysis of Trends in Personal and Gross Saving,'' 
Current Issues in Economics and Finance, Federal Reserve Bank of New 
York, Volume 6, Number 10 (September 2000).

Q.17.a. What forms, if any, of bank surveillance are done 
---------------------------------------------------------------------------
through automated technology and/or the Internet?

A.17.a. The OCC has various automated systems to monitor the 
safety and soundness of the national banking system. This 
information is used on an individual bank basis to enable 
examiners and managers to identify potential risk areas and 
better allocate resources through more focused examinations. 
The following highlights both longstanding, as well as recently 
developed systems:

Uniform Bank Performance Reports
    For the past two decades, staff at the OCC and other bank 
regulatory agencies have used the Uniform Bank Performance 
Report (UBPR) to monitor the condition of the banking system as 
well as perform analysis on individual banks. The UBPR packages 
a large amount of data covering balance sheet, income statement 
and off balance sheet components into an information oriented 
format that enables supervisors to evaluate bank specific risk 
profiles and growth trends, as well as comparisons to peer 
groups. Supervisory staff also has the ability to develop 
customized peer groups for banks with unique characteristics 
and in specific geographic areas.

Canary System
    Canary is an automated early warning system designed to 
identify community and mid-size banks that may have high or 
increasing quantities of credit, liquidity or interest rate. 
Canary uses a combination of internal and external models that 
evaluate a bank's prospective profitability, as well as the 
probability of a bank becoming severely troubled under a 
variety of economic scenarios. The system also is used to 
identify banks designated as low risk. These are institutions 
with a low financial risk profile that are subject to 
streamlined supervision. Canary also facilitates the analysis 
of trends across the banking system.

Financial Market Information
    The OCC tracks broad financial market information on the 
banking system as a whole, as well as individual banks. 
Information gleaned from the Internet, Bloomberg Analytics, 
Moody's Structured Finance DataBase, and the proprietary data 
bases of various research firms complement the onsite, bank 
specific information provided by OCC examiners. In addition to 
regular news flow on general matters, financial and commodity 
prices, the OCC tracks specific bank equity, debt, and asset-
backed securities to evaluate current and changing market 
perceptions.

Examiner View
    Examiner View (EV) is the supervisory information system 
used by all examiners who supervise mid-size and community 
banks, Federal branches and agencies, and technology service 
providers, to input examination information into a centralized 
database via personal computers. The system helps the 
supervisory process by facilitating the prompt and consistent 
aggregation of data.

Q.17.b. Does your agency have any plans to augment the role of 
automated technology in gathering and disseminating 
information?

A.17.b. The OCC will continually enhance various reporting 
features of Canary and Examiner View. Enhancements will 
facilitate more focused analyses of banks of varying sizes and 
business activities. Upgrades will also enable more efficient 
supervisory planning and allocation of resources.
    The OCC's Supervision in the Future project is underway to 
prepare the OCC for the demands of future bank supervision. The 
goals of this project are to leverage computer and 
telecommunications technology, and ultimately to use leading 
edge risk analysis methods to improve the efficiency and 
effectiveness of the bank supervision process. One pilot 
project under this broader program is the development of a 
common file format for loan data that will provide more highly 
automated support technology to the credit review aspect of the 
examination process. If the pilot project is deemed successful, 
this type of program may be expanded to other areas of the 
supervision process.

 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES FROM DONNA 
                             TANOUE

Q.1. What do you think is the single greatest potential problem 
that is facing the United States financial system today?

A.1. Over the short run, the greatest concern is declining 
commercial credit quality. With problem loans rising and with 
this trend expected to continue, a downturn in economic 
activity could pose significant problems for some banking 
institutions.
    In addition to concerns about credit quality, the flaws in 
the current deposit insurance system represent significant 
problems that should be addressed. The current system 
exacerbates downturns by requiring the highest premiums when 
banks can least afford to pay, underprices risk in general and 
subsidizes higher-risk institutions in particular, and 
allocates the assessment burden unfairly.
    Over the longer run, industry consolidation presents 
concerns. The risk exposure of the deposit insurance funds is 
increasingly concentrated in relatively few large institutions. 
As these institutions continue to grow and their activities 
become more complex, this poses challenges to bank regulators 
in terms of monitoring and understanding the risk exposures of 
these institutions appropriately and devising effective 
supervisory approaches.

Q.2. While many analysts predict a recovery from the current 
economic slowdown in the second half of the year, there is 
still a chance that the downturn could be worse than expected. 
If the economy were to perform below expectations, what 
consequences would that have for the safety and the soundness 
of the banking system?
    Specifically, I would like to ask about the banking 
system's risk exposure in the following areas:

 Noncurrent Loans
 Credit Card and Consumer Loans
 Mortgage Delinquencies
 Telecommunications Sector

A.2. The ratio of noncurrent loans to total loans is steadily 
rising. The ratio has edged up to 1.12 percent in the first 
quarter of 2001 from 0.92 percent one year earlier. In spite of 
this increase, the banking industry as a whole is in much 
better shape than it was during the last downturn. Noncurrent 
loans represented 3.25 percent of total loans--nearly three 
times higher than the current ratio--when the U.S. economy 
entered the last recession in 1990.
    The credit quality of credit card and consumer loans has 
deteriorated somewhat in the past 2 quarters. The ratio of 
noncurrent credit card and consumer loans has edged up in the 
first quarter of 2001 and the net charge-off rate for credit 
card and consumer loans has also risen in the past 2 quarters. 
The rapid rise in consumer credit and indebtedness in recent 
years may cause the credit quality of credit card and consumer 
loans to deteriorate quicker in the case of further weakening 
in economic conditions. Net charge-off rates for credit card 
and consumer loans were considerably higher in the first 
quarter of 2001 than they were at the onset of the last 
recession.
    Overall, the mortgage delinquency rate has been relatively 
stable in the past few quarters. According to Standard and 
Poor's, 90 day delinquencies of prime and subprime residential 
mortgage-backed securities have shown little increase in the 
early months of 2001.\1\ However, mortgage delinquencies may 
rise, particularly among subprime mortgage loans, if the 
economy weakens further. Amid the weakening economy and rising 
layoffs, the percentage of noncurrent FHA and VA loans has 
risen sharply in recent months (see enclosed chart).
---------------------------------------------------------------------------
    \1\ Standard and Poors, ``All Flat on the Housing Front,'' Ratings 
Commentary, June 15, 2001.
---------------------------------------------------------------------------
    The banking industry has significant exposure to the 
telecommunications sector from their syndicated lending 
activities. Regulators continue to work together and monitor 
banks' exposure to the sector through the Shared National 
Credit (SNC) review. The SNC data are obtained from the 
confidential onsite examination process. Should the Committee 
require more information about the result, it would be best 
handled through a confidential briefing by the appropriate 
regulator.

Q.3. After 5 very good years, the rate of nonperforming 
commercial, industrial, and personal loans increased by 26.6 
percent in 2000. Can you please tell me what stress, if any, 
this places on the banking system, and whether or not you 
expect a similar rate of increase for this current year?

A.3. Although nonperforming loans have recently risen at a high 
percentage rate, they remain relatively low as a percent of 
total loans outstanding (1.12 percent as of March 2001).
    Analysts generally agree that the increases in 
nonperforming loans during 2000 were the result of relatively 
weak loan underwriting in the late 1990's, a slowing U.S. 
economy, and the well-publicized problems that have affected 
certain industry sectors. These conditions are likely to 
contribute to the emergence of additional problem loans during 
the remainder of 2001. As a result, commercial loan losses are 
likely to rise further before stabilizing. Recent indicators 
show that consumer loan losses also are likely to rise in 2001, 
with their ultimate level depending on how the U.S. economy 
fares over the remainder of the year.
    Although it appears likely that nonperforming bank loans 
will again rise at a double-digit rate in 2001, they also are 
likely to remain at manageable levels for the vast majority of 
insured institutions. At the end of 2000, less than 1 percent 
of insured institutions carried noncurrent loans (90 days or 
more past due plus nonaccrual) greater than 6.0 percent of 
total loans. As recently as 1991, almost 7 percent of insured 
institutions carried noncurrent loans above the 6.0 percent 
threshold.

Q.4. Though the delinquency rates for credit card and consumer 
loans are well below the high levels experienced during the 
last economic downturn, they have risen back to levels 
comparable to 1993. What do you think the effects of this 
increase in delinquency rates will be, with regard to both 
consumers and the financial institutions that you regulate?

A.4. With the exception of credit card lending, consumer loans 
have traditionally been one of the best-performing loan 
categories on bank balance sheets. Charge-off rates on credit 
card loans at FDIC-insured institutions remain high, which has 
helped to drive the aggregate consumer loan charge-off rate 
higher. Despite the higher charge-offs, most consumer lenders, 
and in particular credit card lenders, have developed 
sophisticated risk-management practices that have enabled them 
to enhance profitability in a higher-loss environment. However, 
insured institutions also have increased activity in the 
subprime consumer lending market, which has not yet been tested 
in an economic downturn. While it is unlikely that a 
significant number of institutions would fail due solely to 
problem consumer loans, consumer lenders and current risk-
management practices potentially could face a much tougher 
earnings environment if the economy should slow significantly.

Q.5. According to a Mortgage Bankers Association survey, 10 
percent of mortgages backed by the Federal Housing 
Administration are now 30 or more days delinquent. An article 
in the June 12 New York Times stated, ``The mortgage problems 
underscore one main reason many policymakers and economists are 
so concerned about whether the United States will enter a 
recession this year.'' Can you please tell the Committee your 
thoughts and concerns about the high level of mortgage 
delinquency?

A.5. The rise in delinquencies on mortgages backed by the 
Federal Housing Administration (FHA) reflects a potential rise 
in problem mortgage loans made to financially leveraged 
consumers. Past due FHA loans rose to an historical high of 
11.2 percent in the fourth quarter of 2000. In contrast, past 
due conventional loans rose to only 3.1 percent, well below the 
4.3 percent past due rate recorded in the fourth quarter of 
1985. Problems in FHA backed mortgages are likely to appear 
more quickly than in conventional mortgages because FHA 
borrowers also are likely to experience financial problems more 
quickly if economic conditions deteriorate and the labor market 
weakens significantly.

Q.6. I have heard from varying persons that the banking 
industry has significant exposure in the telecommunications 
sector. What is the direct and indirect exposure of banks to 
the fall-out in the telecommunications sector?

A.6. As noted in Answer 2, the banking industry has significant 
exposure to the telecommunications sector from their syndicated 
lending activities. Regulators continue to work together and 
monitor banks' exposure to the sector through the Shared 
National Credit (SNC) review. The SNC data are obtained from 
the confidential onsite examination process. Should the 
Committee require more information about the result, it would 
be best handled through a confidential briefing by the 
appropriate regulator.

Q.7. According to the OCC, consumers are more highly leveraged 
now than at any measured point in history. Not only are debt 
service payments at historic highs, but the increase in debt 
has been financed through instruments other than mortgages. 
Credit card debt is rising very rapidly; the Chicago Sun-Times 
reported that the average credit card debt per household is 
$8,123 and has grown threefold over the past decade. Debt 
service payments constitute over 14 percent of disposable 
income. What do you believe the effects of this high level of 
personal debt will be with regard to consumers, the banking 
sector, and the economy as a whole? If the economic downturn is 
worse than expected, what would be the effect of having so many 
people so highly leveraged?

A.7. Highly indebted consumers could be at high risk in a 
slower growing economy. As income growth slows and unemployment 
rises, these consumers will find it more difficult to service 
mounting debts. Possible negative effects could include rising 
consumer bankruptcies, rising consumer loan charge-offs, and 
reduced consumer spending that could exacerbate an already 
slow-growing economy. According to data from the Federal 
Reserve Survey of Consumer Finances, the burden of debt service 
falls disproportionately hard on families in lower income 
brackets. Consumer credit problems, particularly those in 
subprime loan portfolios, could also fall disproportionately 
hard on consumers in these income classes. Overall, consumers 
have recently assumed mortgage debt at a rapid rate. According 
to data from the Federal Reserve Flow of Funds, nearly $400 
billion in home mortgages was added to the balance sheet of the 
household sector from year-end 1999 to year-end 2000.

Q.8. Remittances are a large and growing economic reality that 
affect millions of people both in America and south of the 
border. It has recently come to my attention that this 
industry, which recent estimates have put at more than $20 
billion annually, often charges high fees and that many of the 
leading companies have been challenged in court for having 
hidden fees. In a New York Times article it is stated that 
``the fees have run from about 10 percent to 25 percent or 
more.'' Do you believe that there are problems in the manner in 
which the bulk of remittances are made today? What steps has 
your agency taken to analyze possible solutions including 
fostering or creating alternative transfer mechanisms?

A.8. We are not aware of major problems within the banking 
industry relative to excessive fees charged for remittances. 
The New York Times article referenced in the question refers to 
the excessive fees paid by Mexican migrants to transfer money 
back to their families in Mexico. Most of the abuses apparently 
involve people without legal status to have banking or checking 
accounts. The article also mentions that new wire transfer 
systems are being developed that will substantially reduce the 
costs of these wire transfers. Instead of the $80 to $90 fees 
that apparently have been charged to some unsophisticated 
customers to transfer $300 to Mexico, the new competitors are 
expected to charge less than one-fourth of that amount. This 
appears to be an example where the marketplace is taking proper 
steps to address abuses by increasing competition.
    A more recent article in the American Banker notes that a 
White House task force is studying a broad array of United 
States-Mexican border issues including this one. The financial 
services industry should take steps to eliminate these types of 
abusive practices by ensuring that consumers are well informed 
and that transaction fees are fair, equitable, and fully 
disclosed. The FDIC will do its part to ensure similar abuses 
do not occur within the banking industry.

Q.9. Former Treasury Secretary Summers has stated that ``all 
high school students should receive a financial education,'' 
and that ``though personal financial education must begin in 
the home, it must continue in the schools.'' Can you please 
comment on the state of financial literacy and education among 
Americans, including any deficiency in this area that should be 
addressed? If you see any deficiencies, what do you believe can 
and should be done with regard to these deficiencies in both a 
broad sense and with regard to your agency? At the hearing I 
asked for information regarding any initiatives that your 
agency has taken, including the Money Smart program. Could you 
please provide this information in your submission to the 
record?

A.9. Enclosed is a copy of my June 21, 2001 letter, pursuant to 
my testimony, that provided information on the FDIC's Money 
Smart Program. Financial literacy fosters financial stability 
for individuals and entire communities. The more people know 
about credit and banking services, the more likely they are to 
increase savings, buy homes, and increase their financial 
health and well being.
    While financial literacy is a universal need, it can be 
particularly critical for individuals with a modest income and 
few, if any, assets. That is why the FDIC created Money Smart, 
a comprehensive curriculum to help adults outside the financial 
mainstream develop positive deposit and credit relationships 
with commercial banks and thrifts.
    The Money Smart program explains basic financial 
instruments, services, and products in 10 instructor-led 
training modules. The curriculum begins with an introduction to 
bank services and progresses to choosing and maintaining a 
checking account, budgeting and saving, the importance of 
credit history, consumer rights and responsibilities, selecting 
and using credit cards, understanding other forms of consumer 
credit, and a very basic introduction to home ownership.
    The FDIC provides the Money Smart curriculum to banks and 
to other organizations interested in sponsoring financial 
education workshops free-of-charge. The FDIC encourages banks 
to work with others in their communities to deliver financial 
education and appropriate financial services to individuals who 
may be unfamiliar with the benefits of having a relationship 
with an insured depository institution.
    In addition, the FDIC and the Department of Labor (DOL) are 
working together to promote financial education and to make 
Money Smart available at employment centers, called One Stop 
Centers, across the country. To facilitate use of the program, 
FDIC and DOL are scheduling orientation sessions for bankers 
and One Stop Centers in urban and rural locations around the 
country.

Q.10. The percentage of commercial and industrial loans that 
are noncurrent, that is, delinquent, has increased over the 
past 3 years. Over the past year, there has been an increase in 
these types of loans held by large banks, while there has not 
been a similar increase among small banks. Do you think that 
increased consolidation has had a negative effect on the 
quality of loans held by large banks?

A.10. The decline in credit quality is attributable to a 
confluence of factors. These factors include a weakening of 
underwriting standards in the optimistic climate of a long run 
economic boom, increasing corporate leverage, and intense 
competition and earnings pressure in the financial services 
sector. It is difficult to identify any independent effect of 
consolidation per se on credit quality.

Q.11. Over the last decade, core deposits have declined as a 
percentage of bank and thrift assets, as individuals have taken 
advantage of new investment options. Declining deposits have 
forced banks to look elsewhere for sources of liquidity. Small 
community banks, which may have limited access to alternative 
funding sources, are increasingly relying on advances from the 
Federal Home Loan Banks as a way to meet their liquidity needs. 
Do you have any comments on this development and its 
implications, if any, for the financial services industry?
A.11. Increased reliance on liabilities other than core 
deposits implies potentially higher and more volatile funding 
costs for banks. However, with appropriate risk-management 
practices, banks can incorporate nondeposit funding into their 
business operations in a safe and sound manner. Indeed, there 
is evidence that many banks are now using FHLB advances to 
hedge interest-rate exposures of their longer-term assets. The 
situations that have raised concerns for FDIC examiners thus 
far have involved institutions with a heavy reliance on 
advances and bank management that did not fully understand the 
risks associated with these instruments. To address such 
concerns, the FDIC issued examiner guidance for reviewing FHLB 
advances late last year.

Q.12. In a speech before the American Bankers Association, 
Federal Reserve Board of Governors Member Edward Gramlich said 
that, ``Higher rates of national savings are among the unsung 
heroes of the good U.S. economic performance in the late 
1990's.'' However, the most recent data from the White House 
shows a substantial decline in personal savings, from over 5 
percent in 1996 to minus 0.9 percent today. Do you think that 
this is a serious problem, and if so, what can we do to 
ameliorate it? What position does this place Americans in if 
the economic slowdown worsens? Finally, what are the effects of 
this decline with respect to national investment levels and GDP 
growth?

A.12. Many policymakers and analysts have expressed concerns 
about the sharp decline in personal savings rate in recent 
years. Related to this decline in personal savings are concerns 
about an increasing level of household debt and reliance on 
foreign capital to fuel domestic investment in the short term, 
as well as longer-term concerns about the adequacy of 
retirement savings. However, the seriousness of this problem 
may depend on how well the official personal savings rate 
captures actual changes in household savings. Some analysts 
argue that the official personal savings rate significantly 
understates household savings because of its inconsistent 
treatment of durable goods, payments from corporations, 
inflation, and taxes, as well as its exclusion of capital 
gains.\2\
---------------------------------------------------------------------------
    \2\ William G. Gale, ``A Crisis in Saving?'' Barrons, August 16, 
1999; Eric M. Engen, William G. Gale and Cori E. Ucello, ``The Adequacy 
of Household Saving,'' The Brookings Institute Working Paper, January 
2000; William G. Gale and John Sabelhaus, ``Perspectives on the 
Household Saving Rate,'' Brookings Papers on Economic Activity 1, 1999.
---------------------------------------------------------------------------
    However, the rising household debt level does raise 
concerns, particularly in times of an uncertain economic 
environment. In spite of lower interest rates, if the economy 
worsens with continued layoffs and a decline in personal 
income, households are likely to face an increase in the debt 
service burden, which is already near its historical high. From 
a macroeconomic perspective, robust consumer expenditures and 
corporate investment that accompanied the decline in personal 
savings were important contributing factors behind robust GDP 
growth in the past few years. Both consumer expenditures and 
corporate investment were funded mainly by government surplus 
and foreign capital. Foreign capital inflows have continued in 
recent months in spite of signs of a sharp slowdown in the U.S. 
economy. However, if the economic situation worsens, foreign 
capital inflows to the United States could drop significantly, 
having an adverse effect on consumption and investment.

Q.13. What steps has the Federal Reserve taken to promote 
technology and innovation in the payments system, and what 
steps should it take? As well, are you concerned that the 
initiation of payments on the Internet, or through another 
electronic means, could affect the safe operation of the 
payment system?

A.13. By issuing guidance that is technology neutral, the 
Federal regulators have sought to foster innovations such as 
Internet banking and Internet-initiated payments. The Federal 
Reserve has taken a number of steps to promote technology and 
innovation in the payments system. For example, the Federal 
Reserve Board recently requested comment on five interim rules 
to establish uniform standards for the electronic delivery of 
notices to consumers, namely: Regulations B (Equal Credit 
Opportunity); E (Electronic Fund Transfers); M (Consumer 
Leasing); Z (Truth in Lending); and DD (Truth in Savings). 
Also, on May 16, the Federal Reserve requested comment on how 
the Board's regulations may be adapted to online banking and 
lending.
    The FDIC has also taken a number of steps to promote 
technology and innovation in financial services and was one of 
the first bank regulators to provide guidance to the industry 
on issues related to technology and payment systems. The FDIC 
has issued more than 20 guidance documents pertaining to topics 
such as Internet banking and payments. Furthermore, to ensure 
that the opportunities and risks associated with technology are 
monitored and responded to a Bank Technology Group was created 
within the Chairman's Office. An important example of steps 
that the FDIC has taken to promote the safe use of information 
technology in banking is the Security Standards for Customer 
Information issued in March 2001. The FDIC worked with the 
other Federal financial institution regulators to develop the 
standards, as required by Section 501 (b) of the Gramm-Leach-
Bliley Act. The standards were crafted to be technology-neutral 
so as not to inhibit innovation. The FDIC continues to work 
closely with the industry and with other Federal and State 
regulators to ensure that safety and soundness is preserved in 
this increasingly networked environment.
    As a public network, the Internet is inherently less secure 
than the traditional payment networks that preceded it. As 
financial institutions connect to the Internet and permit 
payments to be initiated over this channel, additional security 
measures are necessary. The FDIC is committed to monitoring new 
developments in technology and related risks to the banking and 
payment systems. Through supervisory processes, guidance, and 
education, we will continue to emphasize to the industry the 
importance of security and effective controls.

Q.14.a. What forms, if any, of bank surveillance are done 
through automated technology and/or the Internet?

A.14.a. All insured depository institutions are required to 
file consolidated Reports of Condition and Income (Call 
Reports) on a quarterly basis in an electronic format. The 
information is extensively used by the bank regulatory agencies 
in their daily offsite bank monitoring activities. Call Report 
data also is used by the public, the Congress, State banking 
authorities, researchers, bank rating agencies, and the 
academic community. The FDIC is fully responsible for 
maintaining an accurate and up-to-date Call Report database 
readily available to all users through the Internet. The FDIC 
uses the data collected in the Call Reports most extensively 
for supervisory/surveillance purposes in an effort to detect 
emerging risks. The FDIC has several surveillance programs and 
early warning models it uses to achieve these objectives.
    The offsite systems are designed to support FDIC's 
examination and risk assessment functions by identifying 
potential downgrades of CAMELS ``1'' and ``2'' rated 
institutions, flagging institutions with high-risk profiles, or 
calculating capital requirements for institutions projected to 
fail in the short term. The three primary offsite models used 
by the FDIC Division of Supervision (DOS) are Statistical 
CAMELS Offsite Rating system (SCOR), Growth Monitoring System 
(GMS), and Real Estate Stress Test (REST).
Statistical CAMELS Offsite Rating (SCOR)
    In the mid-1990's, the FDIC developed an offsite rating 
tool called SCOR to more effectively and efficiently monitor 
risk to the banking and thrift system. SCOR uses Call Report 
data to identify institutions likely to receive a rating 
downgrade at their next examination. The system uses 
sophisticated statistical techniques to estimate the 
relationship between Call Report/Thrift Financial Report data 
and examination results. SCOR is available to FDIC supervisory 
personnel on the FDICnet and to other regulators, including 
State banking authorities, through the Extranet.
Growth Monitoring System (GMS)
    GMS is an offsite rating tool that effectively and 
efficiently identifies institutions that have grown rapidly 
and/or have a funding structure highly dependent on noncore 
funding sources. GMS is a prospective model that focuses on the 
relationship between loan growth and noncore funding sources. 
Using statistical techniques, GMS analyzes financial ratios and 
changes in dollar balances to identify banks that have 
experienced rapid growth. Plans are to provide the results of 
the GMS to FDIC personnel and other regulators through 
automated technology being developed in the Virtual Supervisory 
Information On the Net (ViSION) project.
    The purpose of ViSION is to provide an integrated, state-
of-the-art technology solution to support the Division of 
Supervision. ViSION will create a system that will enable DOS 
staff to perform their work within an integrated system. When 
completed, staff will have the ability to review, process, and 
distribute examination reports, offsite analysis reports, 
applications, risk-related premium assessments, and 
correspondence within the system. Such a system envisions data 
being manually or electronically entered into the new system 
only once and electronically manipulated thereafter.
Real Estate Stress Test (REST)
    REST identifies financial institutions likely to be 
vulnerable to a real estate crisis similar to what occurred in 
New England in the early 1990's. REST attempts to simulate what 
would happen to banks today if they encountered a real estate 
crisis similar to that of New England. Plans are to provide the 
results of REST to FDIC personnel and other regulators through 
automated technology being developed in the ViSION project.
    Other offsite tools used by the FDIC include the Uniform 
Bank Performance Report (UBPR) and the Large Insured Depository 
Institution Program (LIDI). The UBPR is a report available to 
the public on the Internet that uses the Call Report data to 
provide information (ratios, percentages, and dollar amounts) 
on individual bank performance. Each UBPR also includes data 
for the bank's peer group averages and percentile rankings for 
most ratios. The comparative and trend data contained in these 
reports complement the offsite analysis process performed prior 
to examinations.
    The LIDI is a Division of Supervision quarterly review of 
the industry's largest banks and thrifts. Its purpose is to 
assist staff by culling company-specific and market information 
on the largest financial entities. The information is detailed 
on the LIDI web page and facilitates continuous offsite 
monitoring of the largest insured financial entities. A central 
component of the site is timely analytical reports prepared by 
case managers of the Division of Supervision that summarize 
current developments and risks facing an institution.

Q.14.b. Does your agency have any plans to augment the role of 
automated technology in gathering and disseminating 
information?

A.14.b. The FDIC does plan to use automated technology to 
gather information about financial institutions. A future 
module in ViSION known as Risk Management, will ``crawl'' other 
web sites (newspapers, SEC filings, First Call, etc.) looking 
for information on a regulated entity and join this information 
with existing Call Report, UBPR, SCOR, GMS, and systems from 
other regulators to identify increasing risk in a bank. As far 
as other gathering and disseminating of information, 
FDICconnect is being designed to be the business to Government 
(B2G) connection where banks and other FDIC business partners 
can submit information such as 
applications, bills, make payments, ask questions, and receive 
information such as assessment bills, exam reports, approved 
applications, Financial Institution Letters. FDICconnect 
recently started a pilot with 86 banks and can conduct a very 
small number of transactions. FDICconnect also was initiated to 
meet an Executive Order to have each agency provide an 
electronic means to transact business with Government agencies 
by 2002 or 2003.









 RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES FROM ELLEN 
                            SEIDMAN

Q.1. What do you think is the single greatest potential problem 
facing the United States financial system today?

A.1. Both the nature and magnitude of risks facing the thrift 
industry change over time. At this point, a shift in funding 
sources away from low-cost retail deposits over the past 5 to 
10 years is currently the most noticeable risk for the thrift 
industry. Asset quality concerns remain subdued. However, we 
continue to closely monitor asset quality trends, which are 
very sensitive to changes in the U.S. economy.
    Retaining low-cost stable deposits has become a challenge 
for the majority of financial institutions. Competition 
continues unabated. Disintermediation has forced financial 
institutions to seek alternative funding sources. Wholesale 
borrowings have become an increasing important source of 
funding for some institutions in recent years. We are 
continuously monitoring and assessing risks associated with 
this trend.
    As illustrated in the table below, as a percentage of all 
fundings, small balance deposits have declined from 67 percent 
in 1995 to 49 percent in 2000. This decline has been replaced 
by increases in large balance deposits and FHLB borrowings. 



    There are several risks associated with the trend in 
funding sources. The most serious potential risk is the 
liquidity concerns that would result from any flight to quality 
crisis. A significant negative financial or economic event 
could cause investors to move money into safe instruments, such 
as U.S. Treasuries, and to discontinue lending arrangements to 
smaller businesses. Small and medium size thrifts could be 
impacted by this flight to quality regardless of the strength 
of the operations, resulting in liquidity, funding, and 
operational problems for these institutions. This type of risk 
is greatest among institutions that engage in secondary market 
activities and are dependent upon private funding sources for 
the continued sale of loans held for sale. Over the past 5 
years, several thrifts and holding companies have experienced 
disruptions in this regard.
    In each case, the institutions were engaging in higher risk 
lending such as auto, subprime, or high loan-to-value 
mortgages. In each case, the thrift successfully managed the 
difficulties. We consistently assess the liquidity risk and 
contingency plans for thrifts and holding companies engaged in 
this type of activity.
    The other funding risk faced by thrifts is the higher cost 
associated with borrowed funds and noncore deposits. Thrifts 
with increased reliance on these funding sources must 
consistently pay higher rates and are prone to rate spikes due 
to increased competition or a rise in overall interest rates. 
Thrifts can experience a compression in the interest margin, 
and there is the risk that thrift management will shift to 
higher risk activities to offset the decline in interest 
spread.
    Institutions that rely on borrowings sometimes opt to use 
complex instruments that require sophisticated analysis to 
evaluate the risk thoroughly. We have issued several bulletins 
to the industry warning of the risk associated with these 
complex instruments and setting standards for the evaluation of 
the risks. In addition, we have recently enhanced our interest 
rate risk model to account for impact of complex debt 
instruments on a thrift's interest rate risk profile.

Q.2. While many analysts predict a recovery from the current 
economic slowdown in the second half of the year, there is 
still a chance that the downturn could be worse than expected. 
If the economy were to perform below expectations, what 
consequences would that have for the safety and the soundness 
of the banking system?

A.2. Despite the recent weakness in economic activity, the 
overall financial condition and performance of the thrift 
industry is strong. The level of credit quality in the thrift 
industry has remained high--in part due to the industry's 
concentration in residential mortgage lending and its limited 
exposure to commercial lending. In general, while the overall 
quality of conventional residential mortgage loan portfolios 
has remained high, the sharpest deterioration in credit quality 
has occurred in the commercial, industrial, and nontraditional 
mortgage sectors of the market. For instance, the chart below 
shows the percentage of subprime mortgages, tracked by the 
Mortgage Information Corporation that were in foreclosure over 
the last 8 quarters. The data includes all grades of first lien 
subprime mortgages. Since June 2000, the percentage of the 2.3 
million subprime mortgages in foreclosure has increased by 47.3 
percent, from 3.19 percent to 4.70 percent. Not shown in the 
chart is a similar deterioration in the percentage of these 
mortgages that are 30 days or more past due, which, as of March 
2001, stood at 11.59 percent. The only positive news is that 
although the June quarter illustrates further deterioration in 
the subprime portfolio, the rate of increase in delinquencies 
is not as large as it has been over the last 3 quarters. 



    The thrift industry's loan portfolio is heavily dependent 
on the financial health of consumers since over 50 percent of 
thrift assets are held in direct loans to individuals 
residential mortgages (48 percent of assets) and consumer loans 
(6 percent). We continue to monitor the economic factors that 
impact the performance of consumer debt. The number of personal 
bankruptcies continues to increase, and the debt burden 
shouldered by consumers is near an all-time high. In response, 
we closely monitor the risk-management practices of thrifts, 
especially ones that have higher levels of unsecured consumer 
lending or engage in high loan to value mortgage lending. 
However, the impact of higher bankruptcies on most thrifts will 
be muted due to the collateral coverage of real estate loans. 
Although the level of subprime lending is not pervasive, it is 
one of the fastest growing business segments in the banking and 
thrift industries. We continue to closely monitor thrifts with 
significant levels of subprime assets and note that some 
institutions have begun to retrench their activities in this 
area. While subprime lending can be profitable, some insured 
institutions have entered this business line without the 
appropriate risk-management practices, reserves, or capital 
support, and a disproportionate number of problem situations 
and failures have resulted.
    The thrift industry's overall financial condition at this 
point in the economic cycle is quite strong, and its level of 
capital and reserves is more that adequate to absorb higher 
levels of loans that might be expected should the economy 
perform below expectations for some period.

Q.3. After 5 very good years, the rate of nonperforming 
commercial, industrial, and personal loans increased by 26.6 
percent in 2000. Can you please tell me what stress, if any, 
this places on the banking system, and whether or not you 
expect a similar rate of increase for this current year?

A.3. Troubled assets, which include seriously delinquent 
(noncurrent) loans and repossessed assets, climbed to 0.62 
percent of total savings and loan assets as of March 31, 2001, 
from 0.60 percent at year-end 2000. Troubled assets reached a 
record low of 0.58 percent of assets in the third quarter of 
2000. As of the end of March 2001, noncurrent loan rates (loans 
over 90 days past due or in nonaccrual status) increased to 
0.53 percent of assets from the year-end 2000 level of 0.50 
percent. Noncurrent consumer loans stood at 0.83 percent of 
consumer loans as of March 31, 2001, up from 0.81 percent at 
year-end. Noncurrent commercial loans jumped to 1.64 percent of 
all commercial loans at the end of March from 1.52 percent at 
the end of 2000.
    While the recent increase in nonperforming consumer and 
commercial loans has put downward pressure on earnings, the 
current level of nonperforming loans in the thrift industry is 
still relatively low. To date, nonperforming loans have not 
placed an undue level of stress on the thrift industry. Indeed, 
the earnings of the thrift industry have remained strong by 
historical standards and the industry as a whole is adequately 
reserved and well capitalized. Moreover, in contrast to 
noncurrent loans, delinquent loans (those 30 to 89 days past 
due) actually declined for most types of loans during of the 
first quarter of 2001. While the recent decrease in delinquent 
loans 30 to 89 days past due is encouraging, our ability to 
foresee turning points in the credit cycle is limited, and 
continued weakness in economic activity is likely to cause 
credit quality to erode.

Q.4. Though the delinquency rates for credit cards and consumer 
loans are well below the high levels experienced during the 
last economic downturn, they have risen back to levels 
comparable to 1993. What do you think the effects of this 
increase in delinquency rates will be, with regard to both 
consumers and the financial institutions that you regulate?

A.4. The increase in delinquency rates on consumer loans in 
general and credit cards loans in particular is likely to 
result in some tightening of credit standards, making it more 
difficult and costly for marginal borrowers to obtain credit. 
In addition, financial institutions are increasingly imposing 
automatic increases in credit card lending rates when payments 
are past due.
    As noted above, noncurrent consumer loans stood at 0.83 
percent of all consumer loans as of March 31, 2001, up 0.81 
percent at the end of last year. The consumer loan noncurrent 
rate is well below the recent peak of 1.32 percent reached in 
1991. The recent increase in consumer loan delinquencies has 
not had a significantly adverse effect on the thrift industry 
in part because the noncurrent rate is still relatively low. 
Moreover, only 6.3 percent of the industry's assets are in the 
form of consumer loans. Nevertheless, the rise in delinquencies 
is likely to prompt some thrift institutions to improve risk-
management practices, boost reserves, tighten lending standards 
and increase lending rates and late fees.
    The effect of higher delinquency rates on the availability 
of credit is uncertain. We have seen a continued increase in 
personal bankruptcies over recent periods; which has not been 
accompanied by reduced credit availability. One factor that may 
account for this effect is the use of improved tools for risk 
adjusted loan pricing, such as credit scoring and automated 
underwriting systems. Therefore, financial institutions have 
continued to lend to consumers with various levels of credit 
risk.

Q.5. According to a Mortgage Bankers Association survey, 10 
percent of mortgages backed by the Federal Housing 
Administration are now 30 or more days delinquent. An article 
in the June 12 New York Times stated, ``The mortgage problems 
underscore one main reason many policymakers and economists are 
so concerned about whether the United States will enter a 
recession this year.'' Can you please tell the Committee your 
thoughts and concerns about the high level of mortgage 
delinquency?

A.5. The vast majority of mortgages held by thrifts are non-FHA 
insured, single-family mortgages. FHA mortgages are typically 
made to low- and moderate-income families and many first-time 
homebuyers. Although thrifts originate FHA mortgage loans, they 
typically sell them to investors in the secondary market.
    The delinquency rate on FHA mortgages is considerably 
higher than the delinquency rate on non-FHA, single-family 
mortgages. The delinquency rate on single-family mortgages held 
by thrifts was only 1.67 percent as of March 31, 2001, slightly 
above the 10 year low of 1.66 percent in 1999.
    The difference in the performance of the FHA mortgages 
relative to the mortgages held by insured depositories has 
widened considerably. According to data from the Mortgage 
Information Corporation, the difference in performance (as 
measured by 30 days past due) was negligible in the early 
1990's. As of the first quarter of 2001, FHA loans had a 
delinquency rate 5 times higher than that of conventional 
mortgages held by depository institutions.
    The overall credit risk of the FHA mortgages has been 
affected by increases in ARM lending, and by higher effective 
loan-to-value lending programs. It has also been affected by 
the ability of private sector lenders to offer more 
creditworthy borrowers better terms than before, thus lowering 
the credit quality of the pool of FHA borrowers, as those able 
to get better terms elsewhere forego FHA loans. While the rise 
in delinquencies of FHA mortgages is a matter of concern, the 
thrift industry exposure to that sector of the mortgage market 
is limited.

Q.6. I have heard from varying persons that the banking 
industry has significant exposure in the telecommunications 
sector. What is the direct and indirect exposure of banks to 
the fallout in the telecommunications sector?

A.6. Fitch Investors Service reports that telecommunications 
defaults for the first half of the year reached $15.5 billion 
or 1.4 percent for the sector. Although many telecom companies 
continue to struggle, there is minimal direct exposure to the 
thrift industry. The troubled telecom companies will mainly 
affect U.S. commercial banks. Mostly impacted by this fallout 
are banks that have underwritten a company's bond offering or 
the larger commercial banks that have private equity 
investments in these companies.
    Nevertheless, the thrift industry could experience some 
indirect exposure through a rippling effect. If the financial 
stability of these companies remains uncertain or worse, it may 
adversely impact the surrounding area in which the business 
operates. The most material indirect impact for thrifts would 
be a decline in home values. However, most of the markets that 
have a concentration of telecom companies also have relatively 
diversified economies.
    There is also some limited exposure if a telecommunication 
company is providing services to a thrift. The inability of a 
troubled telecommunication company to support the institution's 
system may cause continuity of service problems and create a 
reputation risk for the institution. Therefore, the quality of 
a thrift's contingency plan is key to its success in overcoming 
any failure. In addition to having a solid contingency plan, 
management should fully understand each vendor's capabilities, 
financial viability, and the extent of repercussions if 
disruption of service occurs. Further, management must 
understand the importance of utilizing a company with a sound 
infrastructure. These steps should help mitigate any potential 
failures within the telecom sector.

Q.7. According to the OCC, consumers are more highly leveraged 
now than at any measured point in history. Not only are debt 
service payments at historic highs, but the increase in debt 
has been financed through instruments other than mortgages. 
Credit card debt is rising very rapidly; the Chicago Sun-Times 
reported that the average credit card debt per household is 
$8,123 and has grown threefold over the past decade. Debt 
service payments constitute over 14 percent of disposable 
income. What do you believe the effects of this high level of 
personal debt will be with regard to consumers, the banking 
sector, and the economy as a whole? If the economic downturn is 
worse than expected, what would be the effect of having so many 
people so highly leveraged?

A.7. Consumer spending constitutes two thirds of our economy. 
Consumer debt finances much of this spending. High levels of 
consumer debt provides an immediate benefit to the consumer 
(increased consumption), to the banking sector (as provider of 
financial services), and promotes current economic growth. That 
is not to say, though, that high levels of household debt are 
not without costs and risks.
    The cost of borrowing against future income to finance 
current consumption (as opposed to investment) is that it will 
eventually reduce future consumption. The risk of leverage is 
that income might become insufficient to service the debt, 
causing delinquencies and eventually, bankruptcies, creating 
costs not only for the consumer, but also for the banking 
sector and the economy as whole.
    Three recent developments may affect consumers' ability to 
service their high level of debt. The first is the Federal 
Reserve's recent repeated cuts in interest rates. This will 
tend to lower consumers' servicing costs, as, for example, when 
they refinance their mortgages. The second is the recently 
enacted tax cuts, which will leave consumers with more after-
tax income to service their debt. The third countervailing 
development is the current economic slowdown, which will tend 
to reduce income, thus making debt servicing more difficult for 
many.
    If the economic downturn is sharper and more prolonged than 
expected, we would expect that payment delinquencies and 
bankruptcies to rise, for the banking sector to face increasing 
loan and revenue losses, and an economic recovery to take 
longer, as consumer credit would become less available. For an 
assessment of the specific impact on the thrift industry, see 
our answers to question 2 and 4.

Q.8. Remittances are a large and growing economic reality that 
affect millions of people both in America and south of the 
border. It has recently come to my attention that this 
industry, which recent estimates have put at more than $20 
billion annually, often charges high fees and that many of the 
leading companies have been challenged in court for having 
hidden fees. In a New York Times article it is stated that 
``the fees have run from about 10 percent to 25 percent or 
more.'' Do you believe that there are problems in the manner in 
which the bulk of remittances are made today? What steps has 
your agency taken to analyze possible solutions including 
fostering or creating alternative transfer mechanisms?

A.8. The cross-border transfer of money between Mexicans who 
work in the United States and family members in Mexico is a 
financial service that is largely provided outside the insured 
depository banking system. These ``remittances'' represent an 
activity valued by ethnic market segments that the traditional 
banking sector has not fully recognized as a worthwhile 
business opportunity. OTS has been active in encouraging 
thrifts to understand the changing demographics of their 
communities and to explore the needs of emerging markets. We 
support institutions that develop creative products to respond 
to underserved communities and that implement these business 
initiatives responsibly and in a strategically and financially 
sound manner.

Q.9. Former Treasury Secretary Summers has stated that ``all 
high school students should receive a financial education,'' 
and that ``though personal financial education must begin in 
the home, it must continue in the schools.'' Can you please 
comment on the state of financial literacy and education among 
Americans, including any deficiency in this area that should be 
addressed? If you see any deficiencies, what do you believe can 
and should be done with regard to these deficiencies in both a 
broad sense and with regard to your agency? At the hearing, I 
asked for information regarding any initiatives that your 
agency has taken, including the Money Smart program. Could you 
please provide this information in your submission to the 
Record?

A.9. Anecdotal evidence suggests and is now confirmed by a 
recent study by the Fannie Mae Foundation on financial literacy 
education in the United States (see attached) that an 
increasing number of public and private sector entities are 
taking a more active role in helping to improve the ``financial 
literacy'' of Americans. From our vantage point, we have 
noticed a significant increase in the involvement of insured 
depository institutions in financial literacy initiatives 
through in school banking programs, homebuyer education 
programs, and other financial education initiatives targeted at 
youth, the elderly, lower income families, new immigrants, 
Native Americas and others.
    Many Americans lack basic skills in the management of their 
personal finances. According to the JumpStart Coalition, many 
young adults are unable to balance a checkbook and do not 
understand financial principles involved with earning, 
spending, saving and investment. Many young adults establish 
poor financial management habits, and accumulate high consumer 
debt. Moreover, the population of new immigrants in this 
country is growing. This poses additional challenges given the 
language and cultural barriers that often exist, as well as a 
lack of understanding distrust of the banking system. The rise 
in elder financial abuse, bankruptcies and predatory lending 
problems is in part attributed to poor financial decisions and 
the ability of others to prey on those who are financially 
vulnerable or unsophisticated.
    Deficiencies that we have observed with respect to 
financial literacy programs are the lack of resources 
(financial or human) to sustain programs or to expand their 
reach to a broader audience. Moreover, there is not a good 
system nationally for sharing best practices and program 
curriculum--be they employer based, community based, or in 
school programs.
    Employer based educational programs and school based 
programs are excellent ways to reach very large populations of 
people. However, this type of training is generally not part of 
the school curriculum nor is it offered is most workplace 
settings. We would recommend urging more employers to offer 
personal finance courses dealing with wealth creation, avoiding 
financial problems or pitfalls, money management, savings and 
investment strategies and retirement planning. Probably the 
best time and place for people to learn the importance of money 
management and wealth creation is in schools. In school banking 
programs have had success in certain communities, as have 
volunteer in school training programs such as Junior 
Achievement and the JumpStart Coalition. Promoting and 
supporting in school financial literacy programs is equally 
important.
    In underserved populations, community and faith-based 
organizations play a major role in meeting the need of 
individuals in these communities. These organizations are often 
able to provide more than financial education. Support programs 
aimed at life planning issues are often needed by many 
individuals in addition to practical money skills. However, the 
resources of these organizations are usually very limited and 
must be used to address a variety of community development or 
social service needs. Thus, these entities are well positioned 
to reach a large segment of the market but are not well 
equipped with the resources.
    In addition to employer and school based programs, and 
programs offered through community and faith-base 
organizations, 
financial education for older Americans should be a priority. 
Financial management can help older adults avoid scams and 
financial abuse, budget, plan, and manage daily money matters. 
Education on alternative sources for healthcare, homecare, 
estate planning and more complex financial products, such as 
reverse equity products if they are homeowners, would benefit 
older Americans.
    OTS established a Community Service Program in 1998. OTS 
employees participate as volunteer tutors in established, 
legitimate financial education programs in local schools and in 
the community as part of the agency's Community Service 
Program. Examples of financial education programs that agency 
staff has participated in over the past 3 years include Junior 
Achievement, American Bankers Association's National Teach 
Children to Save Day, Seahawks Academy Financial Literacy 
Training, Central City Lutheran Mission Financial Literacy 
Training, Operation Hope's Banking of the Future Day and the 
Neighborhood Housing Services of New York Financial Life Skills 
Course.
    OTS participates in the Department of Treasury Partnership 
in Education program, cosponsored with the National Academy 
Foundation (NAF), by hiring summer interns from local high 
schools. The National Academy Foundation is a nonprofit 
educational organization that works to improve the quality of 
education for students and access to career opportunities by 
supporting partnerships between business and public schools. 
OTS employees have also served as board members of the National 
Academy Foundation Advisory Board.
    OTS staff is also active with the Women in Housing & 
Finance Foundation's Personal Finance Committee. The Personal 
Finance Committee, co-chaired by an OTS staff member, provides 
an opportunity for WHF members to offer volunteer-based 
financial education to primarily low-income women and their 
families in the Washington, DC area through partnerships with 
local community organizations such as the Latin American Youth 
Center, Ellen Wilson Community Development Corporation, Girl 
Scouts, Jubilee Jobs, Cornerstone Group, For Love of Children, 
Community Family Life Services, Hopkins House. Most recently, 
we helped organize a financial education session on credit and 
money management that was offered at the Women's Wealth 
Building Symposium, a one day conference sponsored by Fannie 
Mae and the McAuley Institute.
    OTS has produced several financial literacy and consumer 
education publications. Primarily through the Community 
Liaison, a quarterly newsletter edited and produced by the 
Community Affairs staff, OTS works to inform and educate the 
industry about financial literacy issues and to highlight 
programs that the industry is involved in. These consumer 
education materials are available on OTS's web site, 
www.ots.treas.gov, and include:

Individual Development Accounts (IDA's): Strategy for Asset 
Accumulation, November 1998, Office of Thrift Supervision.

``Looking for the Best Mortgage,'' an interagency brochure with 
tips on shopping for a mortgage, 1999.

``Working with America's Youth,'' Community Liaison, June 1999, 
Volume No. 99-02. An article discussing financial literacy 
programs in which some OTS regulated institutions are involved.

``How to Pickle a Coin of Fun Money in Cyberspace,'' Community 
Liaison, June 2000, Volume No. 2000-01. Discussion of financial 
literacy web sites for kids.

``Domestic Financial Abuse of the Elderly,'' Community Liaison, 
September 2000, Volume No. 2000-02. Article about what banks 
can do to combat elder financial abuse.

``The Path to Homeownership,'' Community Liaison, January 2000, 
Volume No. 00-01. Article discusses several programs that 
promote homeownership through vehicles such as IDA's and 
homebuyer education.

``Washington Mutual Opens the Door to Affordable Homeownership 
in Orlando,'' Community Liaison, November 1999, Volume No. 99-
03. This article highlights WAMU's homeownership center that is 
used to educate consumers on the home buying process.

``Hope is Spreading,'' Community Liaison, June 2000, Volume No. 
2000-01. This article profiles Operation Hope's financial 
literacy program.
Q.10. Another disparity involved rules on loans to one 
borrower. National banks are generally allowed to lend no more 
than 15 percent of their capital on an unsecured basis to a 
single borrower. Many States have higher limits for the banks 
they charter. On June 8, 2001, the OCC announced a new pilot 
program allowing national banks with the highest supervisory 
rating to lend up to the State limit--but no more than 25 
percent of capital to single borrowers under certain 
circumstances. Please describe the competitive regulatory 
disparity that led the OCC implement this pilot program.

A.10. This question can more appropriately be answered by the 
OCC. Therefore, we defer to the OCC.

Q.11. In a speech before the American Bankers Association, 
Federal Reserve Board of Governors Member Edward Gramlich said 
that, ``Higher rates of national savings are among the unsung 
heroes of the good U.S. economic performance in the late 
1990's.'' However, the most recent data from the White House 
shows a substantial decline in personal savings, from over 5 
percent in 1996 to minus 0.9 percent today. Do you think that 
this is a serious problem, and if so, what can we do to 
ameliorate it? What position does this place Americans in if 
the economic slowdown worsens? Finally, what are the effects of 
this decline with respect to national investment levels and GDP 
growth?

A.11. This answer can more appropriately be answered by the 
Federal Reserve Board. Therefore, we defer to the Federal 
Reserve Board.

Q.12. What steps has the Federal Reserve taken to promote 
technology and innovation in the payments systems, and what 
steps should it take? As well, are you concerned that the 
initiation of payments on the Internet, or through another 
electronic means, could affect the safe operation of payments 
systems?

A.12. This answer can more appropriately be answered by the 
Federal Reserve Board. Therefore, we defer to the Federal 
Reserve Board.

Q.13.a. What forms, if any, of bank surveillance are done 
through automated technology and/or the Internet?

A.13.a. OTS employs automated technology and the Internet to 
conduct surveillance and monitoring activities. OTS developed 
several automated systems to monitor the financial condition 
and performance thrift institutions. These systems include the 
Risk Assessment Model (RAM), the Thrift Monitoring System 
(TMS), and the OTS Net Portfolio Value Model (NPV Model).
    The RAM is used to identify thrifts exhibiting 
characteristics that may lead to a CAMELS rating downgrade. RAM 
uses a series of financial ratios to generate a ``RAM score,'' 
which ranks the likelihood of a ratings downgrade.
    The TMS is used to identify particular areas of thrift's 
operations that may warrant special attention and analyses. TMS 
uses a series of financial ratios to measure adverse trends in 
earnings, asset quality, liquidity, and capital. TMS also 
incorporates Internet links to facilitate access to publicly 
available information. TMS includes direct links to the home 
websites of individual thrift institutions, as well as links to 
sites with stock prices, credit ratings, Securities and 
Exchange Commission filings, and news items. (All OTS analysts 
and examiners have Internet access from their personal 
computers in addition to that provided through TMS.)
    The NPV Model is used to monitor the interest rate risk 
exposure of individual savings associations. The NPV Model 
employs scenario analysis to ``stress test'' the vulnerability 
of thrifts to different interest rate enviromnents. In addition 
to providing a means of identifying thrifts with high levels of 
interest rate risk exposure, the NPV Model allows OTS to 
distinguish between the speculative and nonspeculative use of 
derivatives products.
    OTS has an automated central filing system, the Electronic 
Continuing Exam File (ECEF), which provides OTS staff with 
access to essential information on individual thrift 
institutions. The ECEF contains financial data, correspondence, 
examination reports, enforcement actions, news items, 
monitoring comments and other relevant information. The ECEF 
facilitates examination planning and reduces time gathering 
information prior to an onsite examination.

Q.13.b. Does your agency have plans to augment the role of 
automated technology in gathering and disseminating 
information?

A.13.b. Yes, we are continually exploring ways to take 
advantage of new technology to further the mission of OTS, to 
improve our efficiency and effectiveness, and to minimize the 
burden on the institutions we regulate.
    Since 1993, OTS has provided the thrift industry with 
electronic filing software to facilitate data entry, editing, 
and transmission of regulatory financial reports. The software 
includes validation edits, so the thrifts can check reports for 
errors prior to transmission to OTS. The software saves 
considerable time for both OTS and the industry and helps to 
ensure greater data accuracy. We have enhanced the software to 
provide the industry with the capability of communicating 
electronically with OTS, a significant improvement in 
expediting the data edit/validation process. We are currently 
exploring the use of web-based technology to achieve greater 
efficiencies in data collection and dissemination.
    We have approved an initiative to stand up an Extranet to 
facilitate the secure exchange of information with the 
institutions we regulate and other regulatory agencies. Thrifts 
would use the Extranet to file financial data with OTS, to 
retrieve information for their institution (that is, interest 
rate risk reports, performance data, examination reports), and 
to submit corporate applications (that is branch office, change 
of address) electronically to OTS. The Extranet would also 
serve as the secure, electronic distribution point for data we 
currently share with the other financial regulatory agencies 
via tapes, CDs, etc.
    We are continually adding to the information available 
through our public website to enhance the flow of information 
to thrift institutions and other interested parties. Current 
OTS web content includes: press releases, proposed regulations, 
comments on proposed regulations, OTS contacts, institution 
directory, applications received, CRA public evaluations, OTS 
handbooks, Thrift Financial Report forms and instructions, 
technical bulletins, and more.