Problem Loans at New England Banks, 1989 to 1992: Evidence of Aggressive Loan Policies

by John S. Jordan
January/February 1998

The New England banking industry experienced serious problems between 1989 and 1992. As the region's economy deteriorated, banks failed at an unprecedented rate and many others barely survived. Banking problems were widespread, but they were not uniform. The ratio of nonperforming loans to total loans was in excess of 10 percent for some New England banks, below 1 percent for others, even though all faced the external shock of the collapse in the region's real estate market.

This study attempts to determine whether a 'skills' hypothesis or a 'policies' hypothesis better explains the differences among banks in the severity of their loan problems. The 'skills' hypothesis posits that banks with the greatest loan problems were those that employed managers with deficient skills. The 'policies' hypothesis posits that banks with the greatest loan problems were those that chose higher loan-to-asset ratios, held a greater concentration of riskier types of loans, or accepted riskier loan customers. The author uses an analysis of profit and cost efficiency to help identify the hypothesis that better explains the disparity. He finds evidence in support of the 'policies' hypothesis. Conscious decisions by bank managers regarding the riskiness of their loan portfolios, as well as the level of capital to hold, help explain why some New England banks were able to survive the real estate crisis while others failed.

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