THE ORIGIN AND IMPACT OF 12 U.S.C. 84: THE EVOLUTION OF THE 10 PER CENT LENDING LIMIT GOVERNING NATIONAL BANKS*

Abstract

THIS STUDY serves three purposes: (1) to trace and examine the development of national-bank lending-limit regulations; (2) to synthesize the lessons of history and the financial issues raised by extensive recent debate on the 10 per cent rule into a theoretical framework for evaluating the current law; and (3) to recommend a replacement framework. The history sections outline the purpose of the original 1864 lending limit as well as the nature, reasons, and results of each subsequent change. The intent of the original federal lending limit, as found in the National Banking Act, was to force banks to spread their loanable capital around for the benefit of many customers rather than only a few. Many lending limits imposed by states, which predate the first federal law, had much the same purpose. The benefit-spreading rationale stands in sharp contrast to current views, which regard the original intent of the framework as risk reduction through diversification. Reasons for the exceptions are many and varied. They include: facilitating transactions involving real bills, borrowing to buy war securities, supporting federal credit programs, assisting agriculture, and recognizing new developments in banking and transportation. The lessons of history and the financial issues raised by recent debate on the current law suggest three criteria which an optimal lending limit should meet: (1) ability to discriminate among banks based on the degree of risk as well as the quantity of protective capital available; (2) ease of modification when experience suggests change is desirable; and (3) pressure for banks to reduce risk by encouraging economic diversification. When weighed against the above criteria, the current law is found to have serious shortcomings. It does reduce the risk associated with several bad loans but it creates weak pressure for random rather than more satisfactory systematic diversification. The theoretical framework was used to evaluate three alternative programs. The first, raising the unsecured limit to 20 per cent of capital accounts, would retain most of the drawbacks of the current law. State-wide branch banking, the second alternative, would void any restrictive impact of the per-cent-of-capital-accounts framework. The risk-oriented capital allocation inherent in the Simsbury framework (the third approach examined) would nearly meet the criteria for an optimal lending limit. Selectivity would result from the ability to discriminate among banks with equal amounts of capital but different risk exposure, while ease of modification and pressure for risk reduction would be prominent features.