South-Western College Publishing - Economics  
Banks Behaving Badly?
Subject Money and The Financial System
Topic Banking and the Money Supply
Key Words Inflation, Interest Rates, Unemployment, Investment, Productivity
News Story

Bad loans, defaults, bank failures: the 1980s were full of headlines describing a banking crisis that ended up costing the American taxpayer billions of dollars. The Federal Reserve sent a letter on June 23, 1998, to banks saying that it was concerned about their banks' lending standards and alerting these banks that should the economy stall, borrowers would have trouble repaying their loans. John Medlin, former chairman of the Wachovia Corporation, aired another note of caution; warning that lending practices were the worst he had seen in nearly 40 years. Could it happen again?

There is some concern again that banks are lending too freely, that the standards for borrowing are being relaxed or ignored entirely, that banks are stretching out repayment schedules, exposing the banks to economic risks, especially if the economic stalls or goes into a recession. Although there is little evidence to support the notion of an increasing amount of problem loans, the Fed noted that only 20 to 30 percent of several hundred loans that they had reviewed were properly screened. The Comptroller of the Currency reported that the percent of syndicated loans going to companies already carrying heavy debt and subpar credit ratings rose from 12 percent in 1995 to 17 percent in 1997 to 31 percent the first quarter of this year.

In answer to these charges, the big banks have denied that their lending practices have become lax. They argue that the Fed's survey relied too heavily on smaller or regional banks that might be less cautious. Analysts at the major banks have reported that they are comfortable with the quality of their lending practices. (Updated September 1, 1998)
Questions
  1. What are financial intermediaries?
  2. How do banks create money?
  3. What is the relationship between the Federal Reserve and a commercial bank?
  4. Why must a bank's manager be concerned with both liquidity and profitability?
  5. Why might the Federal Reserve be concerned about an increasing number of problem loans?
Source Timothy L. O'Brien, "Worries About Loans Revive Ghost of 1980's Bank Debacle," The New York Times, July 16, 1998

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