LACK OF DISCIPLI NE FOSTERS DEBT

Debt. It touches everyone. But, to paraphrase Mark Twain, while everybody talks about debt, nobody does anything about it.

The Federal Reserve is no exception.At the annual meeting of the Federal Reserve Bank of Kansas City two weeks ago there was a lot of talk about debt, and a lot of possible solutions were thrown on the table. But the sad consensus was that policy-makers have been inordinately slow in developing answers.

Meanwhile, an $8.2 trillion mountain of debt is throwing an ominous shadow over the U.S. economy. This 1985 figure compares with debt of $4.6 trillion in 1980 and $1.6 trillion in 1970. Credit market debt outpaced nominal gross national product in 1985 by about 2-to-1, and according to Henry Kaufman, managing director of Salomon Brothers, "our debt problem is not going to go away."

The U.S. corporate debt-equity ratio in the non-farm sector reached 76 percent by year-end 1985, against 43 percent in the 1960s. The federal government ran a $220 billion deficit last year. And, as of 1985 the world's less developed countries owed $978 billion to other governments, commercial banks and multilateral development agencies.

Debt is not necessarily a reason for panic if - and this is the big if - borrowers make their payments. When debt payments aren't made, the pool of

funds available from banks and other lending institutions shrinks. As this pool of available funds diminishes, the demand for goods and services - a large percentage of which are purchased with borrowed funds - will be reduced.

If strapped, borrowers are forced to sell assets to make debt payments - usually at fire-sale prices - the value of these particular assets erodes and puts other borrowers into potentially precarious positions. These problems are exacerbated by recessions, when money becomes even more difficult to borrow and available pools of capital become even more scarce.

Many economists believe such a recession is in the works.

Benjamin Friedman, professor of economics at Harvard University, told the conference that an economy weakened by such a chain of events would have great difficulty shaking off the effects of any outside shocks, such as the oil shortages of 1973 and 1979. Such vulnerability is likely to encourage economic policy-makers to try to prevent the United States from entering a recession, Mr. Friedman says.

"On average over an extended period, therefore, U.S. monetary policy is likely to be more expansionary than it would be in the absence of a higher debt ratio," he said.

The drawback of such a policy is that it increases the potential for inflation.

Although an easing of monetary policy may be inflationary, Mr. Kaufman for one says the alternative - deflation - is "a more immediate threat to our economic and financial stability." Lower interest rates, he says, will lighten the heavy load accumulated both in the United States and abroad. In addition, the length of time in which debt can be written off by creditors must be stretched, he maintains, to give debtors a chance to "recoup earning power."

A reduction in the huge federal deficit also would be welcome, he said, but at a time when the U.S. economy seems headed for a recession a radical cutback in federal spending would lead to a "fiscal drag" on the economy.

How did global debt reach such proportions?

Mr. Kaufman lays blame on several factors. Among them are a change in perception toward debt, a tax structure that rewards debt by allowing write- offs for interest payments, deregulation and innovation in the financial markets and the internationalization of finance.

Among the economists gathered here, the perception is that the quality of debt in the United States - be it household debt, corporate debt or government debt - is at its lowest level since the Depression. Bankruptcies and business failures are at their highest levels since the 1930s. The average number of business failures in 1983 was 110 per 10,000, the highest by far since 1932 when the number was 154 per 10,000.

Why have so many risky loans been made? Economists say while many of the events leading to default could not have been foreseen - the rapid drop in commodity prices, for instance - creditors must be held accountable for many of their difficulties. The increase in the number of risky loans has strained the global financial system, yet these loans are still being made.

The federal safety net, economists say, has created incentives to high- risk exposure. Without the market discipline brought on by failures, they hold, there is nothing to rein in creditors. Not that all banks are protected by a federal safety net. Indeed, bank failures in the United States have reached alarming proportions, as those in Maryland, Ohio, Texas and Oklahoma are well aware.

In his paper titled, Regulatory Policies and Financial Stability," Robert A. Eisenbeis, professor of banking at the University of North Carolina Business School, says that over the last 18 months, an average of 2.1 banks and 1.5 savings and loans failed a week. This compares with a failure of eight banks and four savings and loans a year during 1970-1980.

Yet these failures hardly have been spread equally through the system. Those banks and S&Ls that have failed have invariably been small- and medium- sized institutions. When a large bank teeters, it can rest assured the federal agencies are poised with their safety nets.

A strong argument can made that the 10 largest banks must be protected. The disastrous ripple effects of a large bank failure undoubtedly would undermine the confidence in the banking system. By the same token, however, when bank officers are free to operate without the restraints of market discipline, the likelihood of risky ventures increases.

Many economists argue that market discipline is at work even at the larger banks. Certainly it is of little consolation to Continental Illinois Bank & Trust Co.'s shareholders - who suffered heavy losses following the near collapse of the bank - that depositors were protected or that the bank is still operational. Certainly those individuals and institutions were not protected from the shocks of the marketplace.

But the fact is, the bank is still operational and some of its departing officers were "rewarded" with golden parachutes.

When lending institutions move onto unstable ground, the Federal Reserve System normally extends them discount loans, with little or no financial penalty. The absence of such penalties, as Mr. Eisenbeis points out, seems nothing less than subsidization of questionable loans.

How to alleviate the crunch?

"The role of our financial system will need to be redefined, and structural changes and disciplines that are lacking today will have to be imposed," Mr. Kaufman says. If the United States is to shake off the shackles of debt many of the regulatory agencies must be eliminated, he says. These agencies hinder the efficiency of the market and do not understandthe integration of today's global financial system, he said.

Adds Mr. Eisenbeis, "Many of the present problems depository institutions find themselves in are rooted in past regulatory policies." Regulatory practices, he said, have limited arbitrage opportunities and prevented banks

from raising funds in some markets.

Especially worrisome are those regulations, like the deposit insurance structure, that seem to encourage risk taking.

"With government insurance," Mr. Eisenbeis says, "the supplier of funds need only worry about the credibility of the insurer." If that insurer is the federal government, his worries are small indeed.

Mr. Eisenbeis would like to see swept away those regulating policies that limit product and geographic expansion. These polices were designed to promote stability within the system, but have, in fact, made the system more unstable. Institutions with limited geographic area are plagued with undiversified portfolios on both the loan and deposit sides, and must rely on relatively few customers as borrowers and depositors, Mr. Eisenbeis argues.

"Those banks that are having the most difficulty as the result of the crisis in oil and agriculture are those institutions whose activities are not geographically diversified," he said.

As for limitations on product diversification, Mr. Eisenbeis says, institutions such as savings and loans, which rely on a limited number of products, find themselves exposed to shocks in housing or real estate markets.

To prevent dangerous exposure in the event of failure, Mr. Eisenbeis

recommends policies that result in the closure of federally insured institutions when the market value of their net worth reaches zero. To remove incentives to risk taking, he said, pricing reform for deposit insurance is needed as well as a system of placing value and price for both on-balance- sheet and off-balance-sheet risks.

Mr. Kaufman would like to see greater disclosure by participants in

financial markets. Such information should be used as a tool for regulatory agencies to rate the creditworthiness of such institutions. Greater emphasis on equity capital as opposed to excessive use of debt also should be fostered. International cooperation and coordination is a must, he adds.

In their efforts to protect those few troubled financial institutions, U.S. policy-makers have, through their regulatory policies, in fact weakened the system. It seems clear that the key to debt reduction is market discipline. For that market discipline to work, however, institutions must be allowed to fail.

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