Reform poses risk for rural banks - proposed Congressional banking reforms could affect commercial farm credit - U.S. Dept. of Agriculture, Economic Research Service report

Agricultural Outlook, August, 1991

Congress is considering several proposal that could radically restructure the U.S. Banking system. Commercial banks account for the largest share of credit to farmers (35 percent in 1990) and are the primary source of credit to rural nonfarm businesses. As a result, farmers and other rural residents have a significant stake in the final outcome of the reform debate.

The centerpiece of bank reform, H.R. 1505, the "Financial Institutions Safety and Consumer Choice Act of 1991" considers the following major steps:

* recapitalizing the Bank Insurance

Fund (BIF),

* restructuring the deposit insurance

system,

* reorganizing the Federal bank

regulatory agencies,

* removing geographic restrictions on

bank expansion.

* allowing banks to diversify their activities,

and

* permitting nonfinancial firms to own

banks.

Whether all of these issues will be covered in the final legislative package is an open question. The BIF recapitalization is certain to be addressed, and some restructuring of the deposit insurance system is highly likely.

However, possible disagreement among bank regulators (the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC), the Office of Thrift Supervision, and the Office of the Comptroller of the Currency) could stall reorganization of the regulatory system. And controversy surrounding proposals for nationwide banking and removal of the separation between banking and commerce make the outcome hard to predict.

Reform Could Reduce

Number of Rural Banks

The vast majority of rural banks are small and serve local market. Unlike the Bank Insurance Fund, most rural banks are in sound financial shape. And although higher deposit insurance fees will add to operating costs, this would not threaten to overall financial health of most rural banks.

Likewise, removing restrictions on nationwide branching would increase competition for customers in some markets, but the available evidence suggests that most small rural banks would continue to thrive in those markets under the current deposit insurance system.

But if legislation significantly reduces insurance coverage for depositors at most banks while maintaining a "too big to fail" policy for large banks, then nationwide banking, product deregulation, and continued reliance on domestic deposits for insurance assessments could seriously hinder small banks' ability to complete. One result could be significant reduction in the number of small independent banks, including those serving rural credits needs.

The effect of bank reform on rural borrowers will depend not only on the specific provisions of the final legislation, but on local financial market conditions, as well. Because the geographic market for the bank loans tends to be fairly small, limiting competition among rural lenders, these banks will tend to pass increases in operating expenses on to their borrowers.

While competition from the Farm Credit System could hold down interest rates on farm loans, lack of competition for non-farm loans could lead to higher interest rates in some markets if reform increases bank operating costs. This in turn would dampen development prospects of many rural communities.

Bank Insurance Fund

To Be Capitalized

Impending insolvency of the BIF makes recapitalization of the fund critical. Assets of the BIF are comprised of fees paid by insured banks and earnings on investments. Its liabilities are obligations incurred when insured banks fail. As the BIF's expenses for bank failures have risen in recent years, it reserves have declined sharply.

At the end of 1990, the BIF had assets of $16.4 billion and liabilities of $8 billion, leaving a reserve of $8.4 billion. The FDIC, which administers the BIF, currently projects the reserve will be depleted in 1991 and that the BIF will have a deficit of $11 billion by the end of 1992.

Since the FDIC's working capital depends on the size of its reserves, in the absence of recapitalization the FDIC would soon be unable to close insolvent banks. The result threatens a replay of the savings and loan debacle of the 1980's , when insolvent thrifts lost additional billions because the federal agency that insured their deposits could not afford to close them.

To avoid this situation, pending legislation would give the FDIC increased temporary funding for the timely closing of failed institutions.

The deposit insurance fee paid by banks to the FDIC is a fixed percentage of total domestic deposits. To compensate for the depletion of bank insurance fund reserves, Congress in 1989 raised the insurance fee. The fee increased 177 percent between December 1989 and July 1991, to $0.23 per $100 of domestic deposits.

If the typical agricultural bank absorbed the entire increase in operating cost from retained earnings, its annual lending could decrease $185,000 relative to the pre-1990 fee. However, the reduction in lending would reach $380,000 if the entire drop in retained earnings were absorbed by the loan portfolio.

The 1989 legislation also lifted the statutory ceiling on deposit insurance fees, opening the door to additional increases in the future.