Why Banks Won't Lend

By Bernard Baumohl

GREGORY O'DANIEL WAS READY TO play a role in getting the economy back on the road to recovery. The Pennsylvania businessman wanted to lease new machinery and hire a dozen more employees so that his two-year-old firm, Tempco USA, could boost its production of cosmetic cotton pads and facial tissues. But O'Daniel needed financing to do that, so he went to his local bank for a $300,000 line of credit. His company has an unblemished credit history and has been ringing up $600,000 in monthly sales to such customers as Wal-Mart and K Mart. Yet the bank turned him down on the grounds that Tempco's track record wasn't long enough. O'Daniel now has to scale back his plans and lay off four employees.

Susan Karlin suffered a similar fate. The graphic designer, who has managed a profitable studio in Manhattan for seven years, needed more computers and a larger staff to accommodate her growing clientele. When she applied for a $100,000 loan at a large bank, she even agreed to put up $200,000 worth of personal property as collateral. She had no previous history of credit problems. A week later, a lending officer called her with the bad news: "We don't feel comfortable with it." Karlin was upset. "I gave them all the documentation they asked for," she said. "Still they wouldn't give me an explanation for why I was rejected."

Frustrating experiences such as these help explain why the U.S. is having trouble pulling out of its doldrums. Small and medium-size businesses across the country are ready to hire more workers, buy new equipment and lease additional office space. But the financial fuel needed to generate this activity is locked up tight. America's commercial-banking industry, on whom these companies rely for financing, is shying away from its traditional role of taking on new risks. Business loans held by banks have plunged a record 8% since the beginning of 1991, to $594.2 billion. "What will create new jobs and new businesses? It certainly hasn't been lower interest rates," says Jay Goldinger, co-founder of Capital Insight, a securities firm in Beverly Hills, California. "Only one action can jump-start the economy. Banks must start lending again."

The persistent credit crunch has its roots in the go-go lending years of the 1980s, when banks and savings and loan associations issued an extravaganza of careless loans to real-estate sharks and corporate raiders, oil drillers and developing countries. "All you had to do to get a loan in the 1980s was have a pulse," says Jon Goodman, vice chairman of California United Bank. The resulting avalanche of bad loans forced the U.S. to allocate nearly $100 billion to bail out the S&Ls and set aside a $70 billion credit line for cleaning up the banks. To prevent such a disaster from happening again, Congress and the Bush Administration fired off a barrage of tough new banking standards. But when federal regulators began enforcing the new rules with an iron fist, many banks and borrowers started to howl. Last year the Bush Administration ordered regulators to ease up, but so far, most bankers remain fearful that any laxity on their part will bring regulatory punishment or even closure. "The weaker banks want to spend more time trying to clean up their balance sheets than making new loans," says Verne Istock, vice chairman of Detroit's NBD bank.

Gun-shy bankers have gone beyond just turning down new applicants. They have also cut the credit lines of current customers. American Crane Co. of Wilmington, North Carolina, a thriving manufacturer and exporter of mobile crane gear, ran into that problem when its bank cut the firm's $10 million credit line by $1 million. Then one of American's important distributors was forced to shut down completely when another bank decided to cancel that company's credit line entirely. "Banks are just not giving us the breathing room we need," says American CEO Bob Cumming. "The banks themselves will not talk about what is happening, but they are closing down perfectly good businesses."

The credit crunch has hit some regions particularly hard, notably the Northeast and the West. California's 460 banks took a bad hit when property values nose-dived. Nearly 60% of the bank loans in the state were backed by real estate, in contrast to an average of 46% for the U.S. "No one is even going to a bank here because they know how hard it is to get a loan," says Goldinger. "The loan demand is there, but people are so tired of being turned down."

Are American banks stable enough to be lending again? The issue of the industry's health came into the spotlight once more last week when Ross Perot ( suggested during the last presidential debate that the U.S. banking system is in worse shape than the government cares to admit. "Right after Election Day this year, they're going to hit us with a hundred banks . . . a $100 billion problem," he declared. The candidate was referring to a new regulation taking effect Dec. 19 that requires regulators to crack down on banks whose net worth, or capital, is less than 2% of assets. Regulators at the Federal Deposit Insurance Corp. quickly rebutted Perot's remarks, contending that only about 80 weak institutions (total assets: $30 billion) out of America's 12,000 banks will fall below the 2% level. Moreover, only those banks that show no progress toward boosting their capital will be taken over, regulators said.

For the industry as a whole, the outlook seems to be getting brighter, with many banks actually thriving. The total level of bank capital, their cushion against losses, is at its highest since 1966. Despite the weak economy, problem loans have shrunk nearly 6% so far this year. Total bank profits zoomed to a record $15.5 billion in the first half of the year, up from $11.1 billion in the same period two years ago.

If earnings are swelling, why aren't banks willing to take more chances on lending? One reason is that the current interest-rate structure has provided them with a rare opportunity to make a sure-thing return, which banks are exploiting. They can get money from depositors at only 3% interest, then turn around and invest it in riskless medium-term Treasury securities that earn about 6%. The three-point spread is almost pure profit, with few administrative costs. In the past 12 months, lenders have increased their holdings of Treasury bills and notes 23%, to $630 billion, while their portfolio of business loans dropped 4%, to $594 billion.

While those strong profits have pleased bank executives and shareholders, the manner in which they were earned has infuriated the White House and the Federal Reserve. "The banks were not put into the business to take deposits and stick them into government securities," says Deputy Treasury Secretary John Robson. "Banking is not supposed to be a risk-free sport. Frankly, it is time for banks to step up to the plate and start lending again."

Bankers, for their part, complain that the biggest factor inhibiting new lending is the huge regulatory net Washington has thrown over the entire industry. "The banking system is currently overmanaged and controlled by regulators," says Joe Belew, president of the Consumer Bankers Association, a national group of retail banks. "If you squeeze out the risk factor, you also squeeze out a number of debatable lending opportunities. Only people with perfect records will then get the upper hand. But few of us have perfect records." Nor do banks relish the thought of having federal examiners constantly looking over their shoulder. "When you're sitting here with regulators who are coming down and telling you to downgrade everything that isn't lily white, you have a problem," says Don McWhorter, president of Ohio- based Banc One.

The new regulations have forced banks to be highly conservative in judging loans. Lending officers are required to carry out far more documentation, a costly and time-consuming process. They now routinely want business borrowers to provide personal guarantees, sometimes even with their homes as collateral. And if the value of that collateral falls below the outstanding balance of the loan, then bankers may have to classify the debt as being in default -- even though the borrower may have been faithfully making payments.

Lenders have also witnessed the spectacle of seeing S&L executives thrown into jail. This has heightened the fear among bankers and board directors, as well as among their accountants and attorneys, that they could face criminal liability if a loan goes bad and imperils the bank. "There is a real fear among lenders," says Lawrence Hunter, chief economist of the U.S. Chamber of Commerce, "that a bad business decision in this day and age stands the risk of becoming criminal activity."

As the banking industry recovers, its attitude about lending needs to swing back from hypercaution to moderation. This trend could be hastened if government would take another look at its banking regulations and find ways to relax the rules, and restore the risk-taking function of banks, without endangering the health of the FDIC. With interest rates so low, a batch of new loans would go a long way toward invigorating small and medium-size businesses, which are the nimblest sector of the economy and the most likely to provide new jobs in a hurry. Until that happens, no matter who gets elected President, the nascent recovery will be robbed of the oxygen it needs to grow.

CHART: NOT AVAILABLE

CREDIT: [TMFONT 1 d #666666 d {Source: Federal Reserve}][TMFONT 1 d #666666 d {Source: Sheshunoff Information Services Inc.}]CAPTION: Total lending has declined 8% since the beginning of 1991, even though profits have climbed to record levels

With reporting by William McWhirter/Detroit and James Willwerth/Los Angeles