Fed warns banks to tighten grip on loan controls

US banks were warned yesterday by the Federal Reserve to tighten controls on lending, following a study by the central bank that showed significant slippage in the standards applied to loans in the last two years.

In an unusual move, the Fed gave notice to all domestic and foreign banks it supervises that it expected bank examiners to step up their scrutiny of financial institutions and encourage more prudent lending practices.

The Fed said it had identified "noteworthy and measurable" easing in bank lending terms, driven by competition for borrowers in the vibrant economic climate of the last two years.

"This is a critical time for banks to maintain their lending discipline and indeed to continue to enhance their controls and practices where they can," the central bank said in a report signed by Mr Richard Spillenkothen, head of banking supervision.

Although the Fed's research showed no serious decline in the quality of loan books at the institutions it examined, the report said it had discovered a generalised easing in lending terms and standards and suggested banks could start to experience problems if economic conditions turned sour.

"If carried too far, such easing can undermine a bank's financial health, especially if the economy weakens, or the extraordinary recent performance of business profits and cash flow does not persist," it said.

Senior Fed officials have been anxious for some time about the growing anecdotal evidence that banks have been dropping their guard against imprudent lending and taking on much greater risk. Although the financial system is in far better shape than it was in the late 1980s, when high-risk lending - especially to the property sector - exploded in a period of rapid growth, officials are now sufficiently concerned to have issued a formal warning.

Sensitivity to the dangers has been heightened by the Asian financial crisis. US officials have made much of the superiority of their own financial supervision in the wake of the crisis and are especially eager to maintain the fundamental soundness of the US banking sector.

The Fed's analysis uncovered three main sets of problems at US banks: a widespread lack of proper analysis by lenders of the likely future financial performance of their customers; insufficient attention to the pricing of loans to take account of the greater degree of risk in some lending; and the rapid growth in unsecured loans to real estate investment trusts.

The report contained some stinging rebukes for practices it said were common. "After several years of favourable economic conditions, banks should guard against complacency and, in particular, the temptation to base expectations of a borrower's future financial performance almost exclusively on that borrower's recent performance," the Fed said.

The report was issued as the Fed's open market committee began a two-day meeting on interest rate policy. In spite of concerns among some members that inflationary pressures are mounting, the Fed is expected to leave rates unchanged.