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56–415 PDF 2010

S. HRG. 111–414 

EXAMINING THE STATE OF THE 

BANKING INDUSTRY 

HEARING 

BEFORE THE

SUBCOMMITTEE ON 

FINANCIAL INSTITUTIONS 

OF THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED ELEVENTH CONGRESS 

FIRST SESSION 

ON 

THE CURRENT CONDITIONS OF KEY FINANCIAL INSTITUTIONS AND 

EXAMINING THE CONTINUING CHALLENGES THESE INSTITUTIONS 

FACE 

OCTOBER 14, 2009 

Printed for the use of the Committee on Banking, Housing, and Urban Affairs 

( 

Available at: http://www.access.gpo.gov/congress/senate/senate05sh.html 
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

CHRISTOPHER J. DODD, Connecticut, Chairman 

TIM JOHNSON, South Dakota 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

EVAN BAYH, Indiana 

ROBERT MENENDEZ, New Jersey 

DANIEL K. AKAKA, Hawaii 

SHERROD BROWN, Ohio 

JON TESTER, Montana 

HERB KOHL, Wisconsin 

MARK R. WARNER, Virginia 

JEFF MERKLEY, Oregon 

MICHAEL F. BENNET, Colorado 

RICHARD C. SHELBY, Alabama 

ROBERT F. BENNETT, Utah 

JIM BUNNING, Kentucky 

MIKE CRAPO, Idaho 

MEL MARTINEZ, Florida 

BOB CORKER, Tennessee 

JIM DEMINT, South Carolina 

DAVID VITTER, Louisiana 

MIKE JOHANNS, Nebraska 

KAY BAILEY HUTCHISON, Texas 

EDWARD SILVERMAN, Staff Director 

WILLIAM D. DUHNKE, Republican Staff Director and Counsel 

DEAN SHAHINIAN, Senior Counsel 

JULIE CHON, Senior Policy Adviser 

MARK OESTERLE, Republican Chief Counsel 

HESTER PEIRCE, Republican Senior Counsel 

DAWN RATLIFF, Chief Clerk 

DEVIN HARTLEY, Hearing Clerk 

SHELVIN SIMMONS, IT Director 

JIM CROWELL, Editor 

SUBCOMMITTEE ON FINANCIAL INSTITUTIONS

TIM JOHNSON, South Dakota, Chairman 

MIKE CRAPO, Idaho, Ranking Republican Member 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

EVAN BAYH, Indiana 

ROBERT MENENDEZ, New Jersey 

DANIEL K. AKAKA, Hawaii 

JON TESTER, Montana 

HERB KOHL, Wisconsin 

JEFF MERKLEY, Oregon 

MICHAEL F. BENNET, Colorado 

ROBERT F. BENNETT, Utah 

MIKE JOHANNS, Nebraska 

KAY BAILEY HUTCHISON, Texas 

JIM BUNNING, Kentucky 

JIM DEMINT, South Carolina 

JUDD GREGG, New Hampshire 

LAURA SWANSON, Staff Director 

GREGG RICHARD, Republican Staff Director 

(II)
C O N T E N T S 

WEDNESDAY, OCTOBER 14, 2009 

Page 

Opening statement of Chairman Johnson ............................................................. 1 

Prepared statement ................................................................................... 39 

Opening statements, comments, or prepared statement of: 

Senator Crapo ................................................................................................... 1 

Prepared statement ................................................................................... 39 

Senator Merkley ............................................................................................... 2 

Senator Bunning ............................................................................................... 3 

Senator Warner ................................................................................................ 3 

Senator Brown .................................................................................................. 3 

WITNESSES 

Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation .................... 4 

Prepared statement .......................................................................................... 39 

Responses to written questions of: 

Senator Crapo ............................................................................................ 158 

John C. Dugan, Comptroller of the Currency, Office of the Comptroller of 

the Currency ......................................................................................................... 6 

Prepared statement .......................................................................................... 47 

Responses to written questions of: 

Senator Crapo ............................................................................................ 159 

Daniel K. Tarullo, Member, Board of Governors of the Federal Reserve 

System ................................................................................................................... 7 

Prepared statement .......................................................................................... 61 

Responses to written questions of: 

Senator Crapo ............................................................................................ 164 

Senator Vitter ............................................................................................ 166 

Deborah Matz, Chairman, National Credit Union Administration ..................... 9 

Prepared statement .......................................................................................... 68 

Responses to written questions of: 

Senator Crapo ............................................................................................ 169 

Timothy T. Ward, Deputy Director, Examinations, Supervision, and Consumer Protection, Office of Thrift Supervision .................................................. 10 

Prepared statement .......................................................................................... 107 

Responses to written questions of: 

Senator Crapo ............................................................................................ 171 

Joseph A. Smith, Jr., North Carolina Commissioner of Banks, on behalf 

of the Conference of State Bank Supervisors .................................................... 11 

Prepared statement ................................................................................... 147 

Responses to written questions of: 

Senator Crapo ............................................................................................ 176 

Thomas J. Candon, Deputy Commissioner, Vermont Department of Banking, 

Insurance, Securities, and Health Care Administration, on behalf of the 

National Association of State Credit Union Supervisors .................................. 12 

Prepared statement .......................................................................................... 154 

Responses to written questions of: 

Senator Crapo ............................................................................................ 176 

(III)

(1) 

EXAMINING THE STATE OF THE 

BANKING INDUSTRY 

WEDNESDAY, OCTOBER 14, 2009 

U.S. SENATE, 

SUBCOMMITTEE ON FINANCIAL INSTITUTIONS, 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, 

Washington, DC. 

The Subcommittee met in room SD–538, Dirksen Senate Office 

Building, Senator Tim Johnson, Chairman of the Subcommittee, 

presiding. 

OPENING STATEMENT OF SENATOR TIM JOHNSON 

Senator JOHNSON. As Congress and this Committee continue its 

work to stabilize financial institutions and promote our Nation’s 

economic recovery, I have called this hearing today for regulators 

to give us an update on the current conditions of the financial institutions in our country. It is vital that we know what continuing 

challenges and concerns our Nation’s institutions face. Specifically, 

I continue to be concerned about the lending environment for small 

businesses, the capital needs of institutions, and the impact of commercial real estate and other loan portfolios on balance sheets. In 

addition, while many of the large banks in our country have stabilized, the FDIC’s list of troubled banks, many of them small community banks, is growing. 

While restructuring our Nation’s regulatory system is this Committee’s top priority, I do not think we can do that without a clear 

understanding of what is happening within the sector. Concerns 

and problems within individual financial institutions will still exist 

even with a new regulatory structure. Continuing to ensure the 

safety and soundness of viable institutions and the overall financial 

stability of our Nation’s economy is vital to protecting all Americans’ pocketbooks, savings, and retirement. 

I want to thank the witnesses for being here today, and I look 

forward to hearing from each of you regarding any developing 

trends or concerns within the banking industry or throughout the 

economy, and to hear of the regulatory or supervisory steps your 

agencies are taking to respond to these challenges. 

I will now turn to Senator Crapo for his opening statement. 

STATEMENT OF SENATOR MIKE CRAPO 

Senator CRAPO. Thank you very much, Mr. Chairman, for holding this hearing to examine the current status of the banking and 

credit union industry. Failures of small banks continue to grow, 
2 

and the key trouble spots are looming, such as commercial real estate loans. 

According to a recent New York Times article, about $870 billion, or roughly half of the industry’s $1.8 trillion of commercial real estate loans, now sit on the balance sheet of small and medium-sized 

banks. I am interested in learning to what extent the TALF, or 

Term Asset-backed Securities Loan Facility, encouraged capital to 

enter the commercial real estate market and what other steps regulators can and should take to address this problem. 

Many community banks and credit unions have tried to fill the 

lending gap created by the credit crisis. Even with these efforts, it 

is apparent that many consumers and small businesses are not receiving the lending they need to refinance their home loan, to extend or keep their current business line of credit, or to receive capital for new business opportunities. 

Regulators need to be mindful that they strike the appropriate 

balance to bolster capital and meet the credit needs of our economy, and FASB’s new rules on off-balance sheets will create challenges on this point. 

As we begin to explore options to modernize our financial regulatory structure, it is important that our new structure allows financial institutions to play an essential role in the U.S. economy 

by providing a means for consumers and businesses to save for the 

future, protect and hedge against risk, and promote lending opportunities. 

Again, Mr. Chairman, I thank you for holding this hearing. I look 

forward to working with you and others on these issues. 

Senator JOHNSON. Senator Merkley. And I encourage members to 

be brief since there are seven panelists and many questions to be 

asked. 

STATEMENT OF SENATOR JEFF MERKLEY 

Senator MERKLEY. Thank you very much, Mr. Chair, for holding 

this hearing on the state of the banking industry. I want to be very 

clear that I am concerned about the effect of this crisis on our community banks. Our national economic crisis was sparked by the 

preemption of State predatory lending laws, the sale of mortgages, 

and certainly the securitization of these mortgages by Wall Street. 

But it is our community banks who have been hit with repeated 

FDIC assessments, who have seen asset values fall, and who have 

seen their regulators tighten the noose. Unlike institutions that 

were deemed ‘‘too big to fail,’’ our community banks apparently are 

deemed ‘‘small enough to fail.’’ 

Despite the fact that community banks had little to do with causing our crisis, our community banks have been unable to lend. 

They are stuck with a Catch-22 situation where private sector investors are unwilling to deploy money unless the banks have TARP 

money in them, and TARP will not go into small banks out of concern for capitalization. Instead, the small banks are told to raise 

more money. 

I was very skeptical of TARP when first authorized because I felt 

it was focused too much on our Nation’s largest banks. Now, given 

the crisis we are facing in Oregon and across the Nation, it is apparent that we need to speed credit access to the economy, and I 
3 

believe that we need to support the recapitalization of our community banks as one of the best ways to get capital flowing to Main 

Street and get job growth started in our economy. 

Mr. Chair, over the next days and weeks, I will look forward to 

working with you and members of the Subcommittee and full Committee to figure out ways to break this gridlock and get capital 

flowing back to our community banks. 

Senator JOHNSON. Senator Bunning. 

STATEMENT OF SENATOR JIM BUNNING 

Senator BUNNING. I have no opening statement. I want to get to 

questions. Thank you. 

Senator JOHNSON. Thank you. 

Senator Warner. 

STATEMENT OF SENATOR MARK WARNER 

Senator WARNER. I know we have got a lot of panelists. I will 

wait for my questions as well. 

Senator JOHNSON. Senator Brown. 

STATEMENT OF SENATOR SHERROD BROWN 

Senator BROWN. Thank you, Mr. Chairman, and I will be brief. 

Yesterday, I had a roundtable of 15, 16, 17 small manufacturers 

in my boyhood home town of Mansfield, Ohio, a community of 

50,000 that has lost a lot of manufacturing jobs, as much of the 

Midwest and much of the country have. Over and over, the discussion turned to they cannot get credit. You know that. Small business generally cannot get credit. Manufacturers have even more 

trouble getting credit than other small businesses, and auto chain 

manufacturers, auto supply chain manufacturers have even more 

trouble getting credit than other manufacturers. 

They typically went around the table and blamed—they did not 

blame the banks. They mostly blamed regulators, of course. I hope 

that we learn in this hearing what we can do as policymakers to 

increase the flow of credit, especially to manufacturers. It sort of 

goes without saying that pulling us out of this recession—at least 

in historical terms, what pulls us out of recessions are housing and 

manufacturing, especially auto manufacturing, understanding more 

in my State than some others. But it is particularly important that 

manufacturing get the credit it needs. They have people to sell to 

more and more. They have people that are working 30 hours that 

want to work 40, and then they want to hire more people. But they 

cannot do any of that. They have got skilled workers, obviously, but 

they cannot do any of that unless credit is more liquid to them. 

So I ask your assistance in that. I said they blame the regulators. I do not necessarily. I think banks are fearful and cautious, 

for good reasons sometimes, and sometimes not so good reasons. 

But we are counting on you. 

Thanks. 

Senator JOHNSON. Senator Tester. 

[No response.] 

Senator JOHNSON. I would like to welcome our witnesses. I appreciate your taking the time out of your busy schedules to be here 

today. 
4 

Today our panel of witnesses includes: Sheila Bair, Chairman of 

the Federal Deposit Insurance Corporation; John Dugan, Comptroller of the Office of the Comptroller of the Currency; and Governor Dan Tarullo, member of the Board of Governors of the Federal Reserve System. We are also welcoming Debbie Matz, Chairman of the National Credit Union Administration, to the panel for 

the first time since her confirmation over the summer. 

I would also like to welcome Timothy Ward, Deputy Director of 

Examinations, Supervision, and Consumer Protection at the Office 

of Thrift Supervision; Joseph Smith, the North Carolina Commissioner of Banks, on behalf of the Conference of State Bank Supervisors; and Thomas Candon, Deputy Commissioner of the Vermont 

Department of Banking, Insurance, Securities, and Health Care 

Administration, and Chairman of the National Association of State 

Credit Union Supervisors. 

While many of you have already been before the Committee 

many times this year on various topics, today we are continuing 

the important conversation of the state of the banking sector. I will 

ask that the witnesses please limit their testimony to 5 minutes. 

Your full statements and any additional materials you may have 

will be entered into the record. 

Chairman Bair, please begin. 

STATEMENT OF SHEILA C. BAIR, CHAIRMAN, FEDERAL 

DEPOSIT INSURANCE CORPORATION 

Ms. BAIR. Thank you. Chairman Johnson, Ranking Member 

Crapo, and members of the Committee, I appreciate the opportunity to testify on behalf of the FDIC regarding the condition of 

the banking industry and the measures being taken by the FDIC 

to address the challenges facing us in the current environment. We 

meet today just 1 year after the historic liquidity crisis in global 

financial markets that prompted an unprecedented response on the 

part of governments around the world. 

The financial landscape today is more stable than a year ago. 

Conditions appear to be moderating, and the liquidity of financial 

markets has improved. Even as we seek to end the extraordinary 

programs that were effective in addressing the liquidity crisis, we 

recognize that much more work needs to be done to meet the credit 

needs of households and small businesses. 

There is evidence that the U.S. economy is growing once again, 

but bank performance typically lags behind economic recovery, and 

this cycle is no exception. High levels of distressed assets have led 

to weak financial performance at many FDIC-insured institutions. 

These have been concentrated in three main areas: residential 

mortgage loans, construction loans, and credit cards. Continued 

high unemployment threatens to keep loss rates elevated for an extended period. As the economy improves, however, loss rates should 

moderate. 

Looking forward, the most prominent risk during the next several quarters is commercial real estate. Property cash-flows are 

falling due to declining rents and rising vacancies. Also, falling 

property prices will make it difficult for some borrowers to renew 

their financing. 
5 

Given the substantial challenges faced by financial institutions, 

the FDIC maintains a balanced supervisory approach that focuses 

on strong oversight but remains sensitive to economic and real estate market conditions. We support banks’ efforts to lend to creditworthy borrowers and to work constructively with existing borrowers to restructure loans where appropriate. 

I have heard reports that examiners are requiring banks to write 

down sound performing loans. I can assure you that that is not the 

policy of the FDIC. The Federal banking agencies are finalizing 

guidance on commercial real estate loan workouts that will make 

that clear. 

The FDIC has expressed support for making loans to creditworthy borrowers in numerous industry forums and in last November’s interagency statement. In particular, banks should continue 

to provide credit to small businesses, an engine of growth that creates jobs. 

Poor credit quality and weak earnings have led to a surge in 

bank and thrift failures. So far this year, we have had 98 failures. 

While we do not expect failures at the levels experienced in the late 

1980s and early 1990s, our loss rates have been significant. 

To address adverse market conditions, the FDIC has employed 

additional resolution strategies that proved successful in the 1990s: 

loss-sharing agreements and structured transactions. These arrangements allow the FDIC to quickly return assets to the private 

sector, obtain better pricing, and minimize disruption to borrowers 

and communities from a bank failure. They save money for the deposit insurance fund and streamline our resolution workload. 

As a result of increased bank failures, the deposit insurance fund 

is projected to need a new infusion of cash next year. To meet the 

fund’s liquidity needs, we are seeking public comment on a proposal to collect $45 billion through a prepayment of deposit insurance assessments instead of a special assessment. 

In addition, we are implementing a restoration plan that should 

return the fund to a positive balance in 2012 and the reserve ratio 

to the minimum of 1.15 percent within the statutory 8-year timeframe. 

The FDIC will continue protecting insured depositors as we have 

for over 75 years. No depositor has ever lost a penny of insured deposits and never will. 

In closing, I would urge Congress to consider the impact of any 

new legislative initiatives on the structure of the banking industry 

as we emerge from this crisis. If reform measures perpetuate too 

big to fail, there will be a further trend toward consolidation into 

large and more complex institutions at the expense of smaller and 

more transparent competitors. 

I urge Congress to implement policies that will assure continuation of a robust community banking sector, and when institutions 

do fail, as some inevitably will, we need a strong resolution authority that will assure market discipline on all institutions, large and 

small. 

Thank you very much. 

Senator JOHNSON. Thank you. 

Mr. Dugan. 
6 

STATEMENT OF JOHN C. DUGAN, COMPTROLLER OF THE CURRENCY, OFFICE OF THE COMPTROLLER OF THE CURRENCY 

Mr. DUGAN. Thank you, Chairman Johnson, Senator Crapo, and 

members of the Subcommittee. I am pleased to testify on the current condition of the national banking system, including trends in 

bank lending, asset quality, and problem banks. The OCC supervises over 1,600 national banks and Federal branches, which constitute approximately 18 percent of all federally insured banks and 

thrifts, holding just over 61 percent of all bank and thrift assets. 

As described in my written statement, the OCC has separate supervisory programs for large, mid-sized, and community banks that 

are tailored to the unique challenges faced by each. 

Today I would like to focus on three key points. 

First, despite early signs of the recession ending, credit quality 

is continuing to worsen across almost every class of asset in banks 

of almost every size. The strains on borrowers that first appeared 

in the housing sector have spread to other retail and commercial 

borrowers. For some credit portfolio segments, the rate of nonperforming loans is at or near historical highs. In many cases, this declining asset quality reflects risks that have been built up over 

time. 

While we are seeing some initial signs of improvement in some 

asset classes, as the economy begins to recover, it will take time 

for problem credits to work their way through the banking system 

because credit losses often lag behind the return to economic 

growth. 

Second, it is very important to keep in mind that the vast majority of national banks are strong and have the financial capacity to 

withstand declining asset quality. As I noted in testimony before 

the full Committee last year, we anticipated that credit quality 

would worsen and that banks would need to further strengthen 

their capital and loan loss reserves. Net capital levels in national 

banks have increased by more than $186 billion over the last 2 

years, and net increases to loan loss reserves have exceeded $92 

billion. 

While these increases have considerably strengthened national 

banks, we anticipate additional capital and reserves will be needed 

to absorb additional potential losses in banks’ portfolios. In some 

cases, that may not be possible, however, and as a result, there will 

continue to be a number of smaller institutions that are not likely 

to survive their mounting credit problems. 

In these cases, we are working closely with the FDIC to ensure 

timely resolutions in a manner that is least disruptive to local communities. 

Third, during this stressful period, we are extremely mindful of 

the need to maintain a balanced approach in our supervision of national banks. We strive continually to ensure that our examiners 

are doing just that. We are encouraging banks to work constructively with borrowers who may be facing difficulties and to make 

new loans to creditworthy borrowers, although it is true that in today’s weaker economic environment, credit demand among businesses and consumers has significantly declined. And we have repeatedly and strongly emphasized that examiners should not dic-
7 

tate loan terms or require banks to charge off loans simply due to 

declines in collateral values. 

Balanced supervision, however, does not mean turning a blind 

eye to credit and market conditions or simply allowing banks to 

forestall recognizing problems on the hope that markets or borrowers may turn around. As we have learned in our dealings with 

problem banks, a key factor in restoring a bank to health is ensuring that bank management realistically recognizes and addresses 

problems as they emerge, even as they work with struggling borrowers. 

One area where national banks are stepping up efforts to work 

with distressed borrowers is in foreclosure prevention. Our most recent quarterly report on mortgage metrics shows that actions by 

national bank servicers to keep Americans in their homes rose by 

almost 22 percent in the second quarter. Notably, the percentage 

of modifications that reduced monthly principal and interest payments increased to more than 78 percent of all new modifications, 

up from about 54 percent the previous quarter. We view this as a 

positive development since modifications that result in lower 

monthly payments are less likely to redefault. 

While many challenges lie ahead, especially with regard to the 

significant decline in credit quality, I firmly believe that the collective measures that Government officials, bank regulators, and 

many bankers have taken in recent months have put our financial 

system on a much more sound footing. The OCC is firmly committed to a balanced approach that encourages bankers to lend and 

to work with borrowers in a safe and sound manner while recognizing and addressing problems on a timely basis. 

Thank you. 

Senator JOHNSON. Thank you, Mr. Dugan. 

Mr. Tarullo. 

STATEMENT OF DANIEL K. TARULLO, MEMBER, BOARD OF 

GOVERNORS OF THE FEDERAL RESERVE SYSTEM 

Mr. TARULLO. Thank you, Mr. Chairman, Senator Crapo, members of the Subcommittee. Let me begin by echoing a few points 

that my colleagues made in either their written or oral statements. 

First, compared to the situation of 8 to 12 months ago, the financial system has been significantly stabilized. The largest banking 

institutions, each of whose financial conditions was evaluated in 

our stress tests and then announced to markets and the public, 

have raised $60 billion in capital since last spring. We continue to 

see a narrowing of spreads in some parts of the market, such as 

corporate bonds, and in short-term funding markets. 

Second, however, important segments of our credit system are 

still not functioning effectively. Many securitization markets have 

had trouble restarting without Government involvement. Lending 

by commercial banks has declined through much of 2009. This decline reflects both weaker demand and tighter supply conditions, 

with particularly severe consequences for small and medium-sized 

businesses, which are much more dependent on banks than on the 

public capital markets that can be accessed by larger corporations. 

Banks will continue to suffer significant losses in coming quarters as residential mortgage markets continue to adjust. Losses on 
8 

CRE loans, which represent a disproportionate share of the assets 

of some small and medium-sized banks, are likely to climb. The 

strains on these banks, when added to the more cautious underwriting typical of recessions, compound the problems of small businesses that rely on community banks for their borrowing. 

Third, it is important that bank supervisors take an even-handed 

approach in examining banks during these stressful times. We certainly do not want examiners to exacerbate the problems of declining CRE prices and restricted availability of credit by reflexively 

criticizing loans solely because, for example, the underlying collateral has declined in value. At the same time, we do not want supervisory forbearance that will put off inevitable losses, which may 

well increase over time, with attendant implications for the Federal 

Deposit Insurance Fund. 

So it is relatively easy to summarize the situation and state the 

problem. The question on everyone’s mind is when and how it can 

be ameliorated. There are no easy answers, but let me offer a few 

observations. 

We as banking regulators should certainly redouble our efforts to 

ensure that the even-handed guidance we are issuing in Washington will be implemented faithfully by our examiners throughout 

the country. But we should not fool ourselves that even the best 

implementation of this policy will come close to solving the problems caused by significantly reduced demand for commercial properties that were in many cases highly leveraged on the assumption 

of rising asset prices. 

The problems lie deeper. In a weak economy that has, in turn, 

weakened many of our banks, supervisory guidance is neither appropriate for, nor effective as, an economic stimulus measure. At 

the most basic level, the strengthening of CRE markets and a return to a fully healthy banking system depend on growth in the 

economy as a whole, and particularly on a reduction in unemployment. 

I believe that the most important Federal Reserve action to promote CRE recovery is through our monetary policy. Our actions to 

date have helped return the Nation to growth sooner than many 

have expected. Nonetheless, because economic performance remains relatively weak, the Federal Open Market Committee indicated after our last meeting that conditions are likely to warrant 

exceptionally low levels of the Federal funds rate for an extended 

period. 

The Federal Reserve has also taken a series of steps to increase 

liquidity for financing capital of interest to consumers and small 

businesses, including the TALF program, which we recently extended through March, with a longer extension for commercial 

mortgage-backed securities. 

I suspect, though, that more direct efforts may be needed to 

make credit available to some creditworthy small businesses. Congress and the Administration may wish to consider temporary targeted programs while conditions in the banking industry normalize. 

Thank you very much, Mr. Chairman. 

Senator JOHNSON. Thank you. 

Ms. Matz. 
9 

STATEMENT OF DEBORAH MATZ, CHAIRMAN, NATIONAL 

CREDIT UNION ADMINISTRATION 

Ms. MATZ. Thank you, Chairman Johnson, Senator Crapo, and 

members of the Subcommittee. I am pleased to provide NCUA’s 

views on the state of the industry. 

As you have heard from my counterparts, the stress on the entire 

financial sector has translated into a challenging time for financial 

institutions, including credit unions. Nonetheless, I am confident 

that credit unions can and will weather the storm. 

Corporate credit unions pose the most serious challenges to the 

credit union industry. Corporate credit unions are wholesale credit 

unions created by retail credit unions to provide investment services, liquidity, and payment systems. For four decades, this system 

worked well. However, in 2008, corporate exposure to mortgagebacked securities created tangible liquidity difficulties. In response 

to a growing crisis, NCUA asked Congress to increase the borrowing ceiling on our back-up liquidity source—the Central Liquidity Facility. Congress granted NCUA’s request, and it is clear to me 

that if you had not acted in such a swift and decisive manner, the 

entire credit union system, not just the corporate network, would 

have been in serious jeopardy. 

Despite this successful intervention, problems continued. In 

March, the two largest corporates were placed into conservatorship 

by NCUA due to the deterioration in their portfolios. Losses flowed 

through the system and resulted in writedowns of capital not only 

by other corporates but by retail credit unions that invested in 

these institutions. Given the tenuous real estate market, NCUA expects additional losses to materialize. 

These conservatorships permit the corporate system to continue 

to function and to serve retail credit unions and, most importantly, 

their 90 million members. Again, a mechanism was developed, the 

Corporate Credit Union Stabilization Fund, which permitted replenishment by the industry over a 7-year period. This spreading 

out of costs was critical as credit union earnings were already experiencing pressures. The Corporate Stabilization Fund has permitted NCUA to maintain its mandated equity ratio in the Share 

Insurance Fund. At no point during this crisis has the equity ratio 

fallen below the 1.2 percent established by Congress, and today it 

stands at 1.3 percent, assuring consumers that their insured deposits are safe. 

Retail credit unions have their own challenges independent of 

the corporates. The good news is that, despite the troubled economy, credit union lending has increased by almost 8 percent since 

2007. However, delinquencies and loan losses have also increased, 

particularly in real estate lending. In 2007, about 0.3 percent of 

such loans were delinquent. The figure now stands at 1.62 percent. 

Industry-wide capital, while still strong, has declined from 11.8 

percent in 2007 to 10 percent. On the one hand, I am encouraged 

by the fact that 98 percent of the 7,700 federally insured credit 

unions are at least adequately capitalized. On the other hand, 21 

credit unions have failed so far this year compared to 18 in all of 

2008. That number could well rise in 2010. Most troubling is the 

increase in credit unions which have been downgraded to CAMEL 
10 

4 and 5. Between December 2008 and August 2009, the assets of 

credit unions in these categories have almost doubled. 

Clearly, credit unions have not been spared from the harsh effects of the economic downturn. In tandem with the assessment of 

corporate losses described above, this presents a difficult road for 

credit unions to travel in 2010 and beyond. 

NCUA has been proactive in our efforts to mitigate the situation. 

NCUA examiners work with credit unions to avoid the riskiest 

types of mortgage lending, and this oversight was complemented by 

the fact that, as member-owned cooperatives, credit unions try to 

put their members into lending products they can afford. As a result, the industry largely steers clear of exotic mortgage lending. 

Only 2.3 percent of all credit union mortgage loans are exotic. 

Additionally, NCUA has enhanced our supervision. We shortened 

our examination cycle. We added 50 examiners in 2009 and anticipate adding 57 more in 2010, and we upgraded our risk management system to identify and resolve problems more quickly. 

NCUA has an obligation to consumers. As a safety and soundness regulator, we will be successful if we preserve strong credit 

unions capable of meeting the financial needs of their members. 

Credit union members rightfully expect a reliable and well-capitalized deposit insurance regime. While the year ahead will be challenging, I am confident that we and the credit union industry we 

regulate will be stronger in the end. 

I welcome the opportunity to answer your questions. 

Senator JOHNSON. Thank you, Ms. Matz. 

Mr. Ward. 

STATEMENT OF TIMOTHY T. WARD, DEPUTY DIRECTOR, EXAMINATIONS, SUPERVISION, AND CONSUMER PROTECTION, 

OFFICE OF THRIFT SUPERVISION 

Mr. WARD. Good afternoon, Chairman Johnson, Ranking Member 

Crapo, and members of the Subcommittee. Thank you for the opportunity to testify today on the financial condition and performance of the thrift industry. 

As of June 30, 2009, OTS regulated 794 thrift institutions with 

combined assets of $1.1 trillion. We also regulated 459 savings and 

loan holding companies with aggregated consolidated assets of approximately $5.5 trillion. Most OTS regulated thrifts are smaller, 

community-based institutions. At the end of the second quarter, 86 

percent of the thrifts had assets less than $1 billion. Three percent, 

or 25 thrifts, had assets greater than $10 billion, and those 25 

large thrifts held 66 percent of total industry assets. 

Thrifts in general are weathering the recession fairly well. Capital overall is strong. The industry’s second quarter earnings improved to break even. And loan loss reserves have been substantially bolstered to near record levels. Because additions to loan loss 

reserves are direct charges to income, the industry’s earnings remain weak by historical standards. Loss provisioning is expected to 

continue at elevated levels until inventories of unsold homes decline, home prices stabilize, and the employment picture brightens. 

Problem assets are continuing to increase, rising to 3.52 percent 

of total assets in the second quarter, up from 2.68 percent 1 year 
11 

earlier. This compares unfavorably to an average level of 0.78 percent from 2000 to 2007. 

These stresses have caused an increase in problem thrifts and a 

general decline in safety and soundness ratings across the industry. As of September 30, 2009, there were 42 problem thrifts representing 5.4 percent of all OTS-regulated thrifts. A year ago, there 

were 16 problem thrifts, or 2 percent of the total. Twelve thrifts 

have failed this year, compared with five last year. The OTS is 

working closely with problem institutions to prevent failures, but 

more thrifts are expected to fail before the economy fully recovers. 

Foreclosures continue to be a concern. Although sustainable loan 

modifications and payment plans to avoid foreclosures are increasing, the number of seriously delinquent mortgages and foreclosures 

in process are continuing to rise. Progress is being made on this 

front, but when so many American families are losing their homes, 

the progress certainly does not seem to be fast enough. 

In summary, Mr. Chairman, it is too early for us to say we have 

hit bottom and the worst is over. We believe significant challenges 

lie ahead as unemployment continues to rise and the housing market continues to work its way through a significant down cycle. Despite these challenges, the overall condition of the thrift industry 

is sound, with strong capital and substantially bolstered loss reserves. Recent earnings have shown signs of improvement, reflecting what we hope are indications that the nation’s economy is beginning to turn around. 

Thank you again for having me here today. I look forward to responding to your questions. 

Senator JOHNSON. Thank you, Mr. Ward. 

Mr. Smith. 

STATEMENT OF JOSEPH A. SMITH, JR., NORTH CAROLINA 

COMMISSIONER OF BANKS, ON BEHALF OF THE CONFERENCE OF STATE BANK SUPERVISORS 

Mr. SMITH. Chairman Johnson and Ranking Member Crapo, 

members of the Subcommittee, I am Joseph A. Smith, Jr. I am 

North Carolina Commissioner of Banks and Chairman of the Conference of State Bank Supervisors, on whose behalf I am testifying. 

Thank you very much, as always, for the opportunity. 

The members of CSBS and our Federal partners, the FDIC and 

the Federal Reserve, supervise 73 percent of the banks in the 

United States, accounting for approximately 30 percent of total 

banking assets. Our banks are not, as a rule, systemically significant. However, they are locally significant in the markets they 

serve, which includes virtually all of the United States. State chartered banks provide healthy competition in urban markets and are 

often the only banks in rural and exurban markets. 

While there are pockets of strength in some parts of the country, 

the majority of my colleagues have characterized banking conditions in their States as, and I quote, ‘‘gradually declining.’’ This 

should be no surprise, given that traditional banks are a reflection 

of the overall health of the economy. 

What cannot be ignored is that the return to health of our largest banks is the direct result of unprecedented, extraordinary efforts by Congress and Federal regulators to ensure their success. 
12 

The majority of banks, however, have not been the beneficiaries of 

this assistance and are experiencing a harshly, harshly procyclical 

regulatory environment, as required by Federal law. This explains 

the tale of two industries you are likely hearing from banks in your 

State versus the news you hear from Wall Street. 

What can or should be done about this? My colleagues and I submit that the place to start is with a vision of what we, the industry, 

policymakers, regulators, and other stakeholders, want the U.S. 

banking market to look like after the current troubles have subsided. In our view, the desirable outcome is a banking industry 

that continues to be competitive, with thousands of banks, rather 

than hundreds or tens, diverse, of banks of various sizes, operating 

strategies, and customer focuses, and strong, with capital, liquidity, 

and risk management sufficient to meet the challenges of the marketplace. 

This is not an argument for the status quo. In fact, my colleagues 

and I are in general agreement with our Federal colleagues that 

our banks have been too concentrated in commercial real estate 

and too dependent on non-core deposits. Where we sometimes disagree with them is on the severity with which we judge banks in 

a down market, the result of which is, in our view, to make bad 

situations worse. I would hasten to add that our disagreements are 

of degree, not kind. We generally agree with the diagnosis. The 

treatment is sometimes debatable. 

To address the current stress of our banks, CSBS respectfully 

suggests, one, that on-the-ground supervisors be given greater latitude to assess the condition of banks based on reasonable economic 

assumptions rather than assumptions of the end of the world. 

Two, that clear rules of the road be established for private equity 

investments and that supervisory applications by strategic investors be expedited once clearly established thresholds have been 

met. 

Three, that the acquisition of distressed banks by healthy banks 

be expedited and at least considered for capital purchase investments under the TARP program. 

Fourth, that troubled banks be allowed to reduce their dependence on brokered deposits in a gradual and orderly way. 

And fifth, that Congress seriously consider revisions to the 

Prompt Corrective Action and Least Cost Resolution provisions of 

FDICIA, which have limited regulatory discretion in the handling 

of distressed institutions. 

While we don’t think that our suggestions will solve all the problems of the banking industry, we do think they can reduce the 

number of failures and the attendant cost to the Deposit Insurance 

Fund, which is, let it be remembered, funded by healthy banks. We 

believe our approach can reduce at least the pace of decline in the 

commercial real estate market with potential positive effects on the 

economy and the recovery. Importantly, it can help preserve the diversity of our financial system that is critical to the future health 

and even viability of our State and local economies. 

Once again, thank you for this opportunity to appear before you. 

I would be happy to answer any questions you may have. Thank 

you, sir. 

Senator JOHNSON. Thank you, Mr. Smith. 
13 

Mr. Candon. 

STATEMENT OF THOMAS J. CANDON, DEPUTY COMMISSIONER, 

VERMONT DEPARTMENT OF BANKING, INSURANCE, SECURITIES, AND HEALTH CARE ADMINISTRATION, ON BEHALF OF 

THE NATIONAL ASSOCIATION OF STATE CREDIT UNION SUPERVISORS 

Mr. CANDON. Honorable Chairman Johnson, Ranking Member 

Crapo, and members of the Subcommittee, thank you for the opportunity to testify. I am the Deputy Commissioner of Banking and 

Securities for the Vermont Department of Banking, Insurance, Securities, and Health Care Administration. I appear on behalf of the 

State Credit Union Regulators as Chairman of NASCUS. Today, I 

will share information on the conditions of State credit unions and 

areas for reform. 

Like all financial institutions, State credit unions have been adversely affected by the current economy. However, at this point, 

State natural person credit unions remain generally healthy and 

continue to serve the needs of their members and their communities. For the most part, natural person credit unions did not engage in many of the practices that precipitated the current market 

downturn. However, we have several issues to bring to your attention about the impact of the economy and the need for capital options for credit unions. 

State regulators remain concerned about unemployment and its 

effects on credit union members’ ability to meet their obligations. 

We also see increases in delinquencies and charge-offs as well as 

pressure on earnings, especially in smaller State credit unions. Although loan delinquency and net charge-offs have increased, State 

regulators indicate that the levels remain manageable. 

In response to this trend, regulators are increasing their oversight of consumer credit products, including auto loans, credit 

cards, real estate and home equity loans. State regulators are also 

closely monitoring member business lending in credit unions. Some 

States, including my home State of Vermont, have not experienced 

the fallout from commercial real estate or subprime lending because State credit unions do not engage in those activities. State 

regulators continue to encourage credit unions to exercise sound 

underwriting practices, proper risk management, and due diligence, as these are the practices that have kept credit unions 

healthier through the economic downturn. 

In anticipation of prolonged economic problems, State regulators 

will closely monitor both lending and investment activities. State 

regulators also emphasize strong governance standards at the credit union board level. We will continue close supervision through offsite monitoring and onsite examinations and visitations. The growing trend toward consolidation is on the minds of State regulators 

as credit union mergers continue to occur, both voluntarily and for 

regulatory purposes. As economic pressures continue, finding suitable merger partners may become more difficult. 

In response to your question about capital needs, access to capital for credit unions is critical. Unlike other financial institutions, 

credit union access to capital is limited to reserves and retained 

earnings. State regulators recommend capital raising options for all 
14 

credit unions. Access to supplemental capital will enable credit 

unions to respond proactively to changing market conditions, thereby strengthening safety and soundness and providing a buffer for 

the Credit Union’s Share Insurance Fund. 

It is NASCUS’s studied belief that a change to the Federal law 

could provide this valuable tool to credit unions without altering 

their nonprofit and cooperative structure. Supplemental capital will 

not be appropriate for every credit union nor would every credit 

union need access to supplemental capital. However, the option 

should be available. 

State regulators are also concerned about the impact of corporate 

credit union losses on natural person credit unions. Given the severity of the losses, it is clear that enhanced regulatory standards 

for capital, governance, and risk management are necessary. State 

regulators are working with the NCUA to ensure the safety and 

soundness of corporate credit unions and to mitigate future risk. 

Last, I would like to emphasize the value of the dual regulatory 

system. State regulators have demonstrated the importance of local 

supervision of State-chartered institutions and the value of the 

dual regulatory system. State regulators have always emphasized 

consumer protection along with safety and soundness as an important part of their mission and accountability to Governors and 

State legislatures. Further, State regulators have the expertise to 

identify areas of risk and take enforcement actions where necessary. As regulatory modernization efforts are considered by the 

Senate Banking Committee, we encourage you to retain State supervision and reaffirm State authority. 

NASCUS and State regulators appreciate the opportunity to testify today. I will be pleased to respond to any questions that you 

have. Thank you, Mr. Chairman. 

Senator JOHNSON. Thank you, Mr. Candon. 

Let us put 7 minutes on the clock for each member to ask questions of our witnesses. 

Ms. Bair, so far, 98 institutions have failed this year and the 

FDIC’s watch list has grown to 416 institutions. How many more 

of the troubled institutions do you anticipate will fail? Is the FDIC 

staffed up to deal with an increase in failures? 

Ms. BAIR. Mr. Chairman, thank you for asking that question. 

There will be more failures. We do not make our failure projections 

public, but failures will continue at a pretty good pace this year 

and next. We think we will have about $100 billion in losses over 

a 5-year period starting at the beginning of 2009. Twenty-five billion of that has already been realized from failures this year, and 

we have already reserved for another $32 billion as of the end of 

the second quarter. 

We are ready for this, though. We have been prepared for some 

time. We started staffing up in 2007, especially in our receivership 

and resolution staff, but also beefing up our examination staff. We 

have 6,300 staff on board now. That number will likely go to 7,000. 

We also have a significant roster of consultants that we use to help 

with bank closings as well as asset valuations, asset management, 

and asset marketing. The FDIC really is designed for this type of 

activity. We can expand very quickly and then contract very quickly. A lot of our hires are temporary 2-year hires. 
15 

Overall, we have got a very good track record. These closings 

have been seamless. Through using loss share, we have been able 

to, more often than not, do a whole bank transaction. So another 

bank that serves that same community acquires both the deposits 

and the assets, which is good for bank customers. Frequently, the 

depositors are also the borrowers at the bank. 

Overall, it has been handled well. I think the staff have made 

a tremendous effort. We are well staffed and very much prepared 

for this. 

Senator JOHNSON. Governor Tarullo, there has been much concern raised that commercial real estate is the next problem area for 

financial institutions. What are the differences between the concerns over commercial real estate and the problems we experienced 

last year with mortgages? 

Mr. TARULLO. Senator, other than the fact that each presents a 

significant and troubled portfolio of assets for financial institutions, 

I think there are some salient differences. 

First, and I think of particular interest to many Members of this 

Committee, the places in which the mortgages are relatively concentrated do vary. As I noted in my opening statement, although 

large financial institutions certainly do have CRA exposures on 

their books, proportionately speaking the exposures are to a much 

more significant extent on the books of smaller and regional institutions, and oftentimes—not always, but oftentimes, those exposures are geographically concentrated. You have a small bank that 

tends to lend in a fairly small area. If the commercial real estate 

market there goes bad, then there is a problem. So, that is number 

one. 

Number two, in commercial real estate, generally speaking you 

don’t have a 30-year fixed mortgage, as you do with residential 

mortgages. Instead, you have loans that need to be rolled over as 

a project proceeds or as a completed project is paid down, and that 

means you have a refinancing problem. So this year and next, we 

have got about $500 billion each year that is going to need to be 

refinanced and that creates a set of challenges that are perhaps no 

more serious than, but different from, the case with residential 

mortgages. 

Third, I would say that while there is some similarity, there are 

some different ways in which the situation plays out. We had 

subprime mortgages. We had Alt-A mortgages, we had prime mortgages, which as you know, Senator, presented ultimately the same 

set of problems, but at different times. In the commercial real estate arena, we have got very different kinds of lending, and there 

is an important distinction between construction and development 

loans, where essentially the builder is just starting to put something on the property, on the one hand, and so-called income-producing properties, a completed hotel or a multi-unit residential 

structure, where there is an income stream. 

The most serious problems are going to be in the former category, with the construction and development loans, which have no 

income stream. You are going to have problems in the second category, but that is something you can at least try to work with in 

some cases. 
16 

Senator JOHNSON. Ms. Matz, I know that the NCUA is currently 

in the process of finalizing new rules for its corporate credit unions. 

Are you considering changes regarding the concentration of risks 

that corporate credit unions can have? 

Ms. MATZ. Thank you for asking that question. As I think you 

are aware, when I was on the NCUA Board in 2002, I was the lone 

member who voted against the corporate rule at that time because 

I felt it didn’t provide adequate parameters on investment authority and concentration of risk. So, we won’t make that mistake 

again. 

At our Board meeting in November, we will take up the proposed 

corporate rule and we will address the riskiest area, which we consider the investment authority. We will set limits on the types of 

securities and the concentration of securities that corporates can 

invest in. We will address capital. We will have stringent requirements for capital retention that will be comparable to Basel I. We 

will set requirements for asset liability management so that asset 

cash-flow and liability cash-flows match. And we will have new 

governance rules, which are not included in the current regulation. 

So, I believe we will address the issues that led to the problems 

we are having today. 

Senator JOHNSON. Ms. Bair, do you have any concerns about 

smaller institutions having risk concentrated in one product area 

or one geographic area? 

Ms. BAIR. Getting back to some of the regulatory reform issues 

that this Committee will be looking at, I think the community 

banking sector is very important to our economy and very important to our country. I do worry that because of competitive pressures and uneven playing fields, that they have become highly concentrated in commercial real estate loans and small business lending. Those are their niche areas where they have been able to hold 

ground against the larger banks as well as the shadow sector. I 

would like to see them be able to diversify their balance sheet, especially in consumer retail, and get back into providing those financial services. So, I do think that this is important. 

But in the near term, clearly, there is a lot of commercial real 

estate on the books of smaller banks. For the most part, they have 

managed those exposures well. Some, though, are more distressed 

than others, and clearly, commercial real estate will be a bigger 

driver of bank failures going forward. 

Senator JOHNSON. Senator Crapo. 

Senator CRAPO. Thank you very much, Mr. Chairman. 

There are a lot of issues that I would like to explore with this 

panel, but in my first round, at least here, I want to focus on one, 

and that is, as I think everybody knows, amidst all the issues that 

we are dealing with here in Congress, one of them, one of the big 

ones that I expect we will be dealing with more aggressively soon 

is the overall financial regulatory restructuring that is being proposed. 

I would like to get the opinion of the members of the panel with 

regard to their thoughts on one aspect of that, and that is the proposal that we consolidate all of the banking regulators into one single Federal banking regulatory agency. I don’t know that in my 7 
17 

minutes I can get through the whole panel, but let us start with 

you, Ms. Bair. 

Ms. BAIR. Thank you, Senator. My position is out there already. 

We have not liked this idea. The proposal was pushed in 2006 as 

an FSA-type model, although I know some of the ideas kicked 

around were a little different from FSA. We fear regulatory consolidation regardless of where it might be located. Clearly there may 

be some room for streamlining of bank regulation, but concentrating all the power with a single entity is a tremendous bet. If 

they do the right thing, then maybe we are OK. But if they do the 

wrong thing, we are really in the soup. 

In particular, taking the FDIC out of the supervisory process and 

the process of setting the capital standards and the underwriting 

standards, et cetera, would go in a different direction from where 

this Committee would like to go. We are not perfect by any means, 

but we are a conservative voice. Since we have a tremendous exposure as deposit insurer, our record shows that we are conservative 

when it comes to supervisory measures. 

Being an examiner also gives us a constant stream of information about banking trends, which helps us a lot in setting insurance premiums as well as helping our examiners prepare for working with the State regulators or the Federal chartering regulators 

when banks get into trouble and have to be wound down and put 

into resolution. 

So, we are very concerned about it. We fear it would weaken the 

FDIC. It could overall weaken banking regulation. 

Senator CRAPO. Thank you. 

Mr. Dugan, do you have an opinion on this? 

Mr. DUGAN. I do. As we testified here on this very subject about 

a month ago, I can’t sit here and defend four separate Federal 

banking regulators and a separate holding company regulator. We 

don’t have four food and drug agencies and the like. But I do think, 

on the other hand, if you moved all the way to one single regulator, 

you get some benefits in efficiency, but you also get some tradeoffs 

of the kind that Chairman Bair just described, that if you take certain regulators out of their current supervision, they don’t keep 

their hand in it to the extent that they otherwise would. 

And so if you asked me, do I think that we can have more consolidation in the industry, I would say yes. But I would say to be 

careful. Each step along way, the trade-offs become more pronounced. 

Senator CRAPO. Thank you. 

Mr. Tarullo, I want to hold off on you yet, because I want to get 

the perspective of the State Bank Supervisors from Mr. Smith before my time runs out, and then we will come back if we can. 

Mr. SMITH. We oppose it from the tops of our heads to the bottoms of our feet—— 

[Laughter.] 

Mr. SMITH.——for the reasons that Chairman Bair has stated, 

and we believe honestly and truly that a single regulator would 

weaken or destroy the dual banking system and think that would 

be a bad thing for America. 

Senator CRAPO. All right. Thank you. 

Mr. Tarullo. 
18 

Mr. TARULLO. Thank you, Senator. So, let me echo the approach 

that Comptroller Dugan took, which is to say in any proposal, you 

are going to have some benefits and you are going to have some 

costs. I think on this one, I would just add two points, or reiterate 

one point and make an additional point. The reiteration is the 

point that Chairman Bair made, which is you lose something, and 

part of what you lose here is the insight that the Federal Deposit 

insurer or the monetary policy authority gets into the functioning 

of the banking system by being an examiner, and that is something 

that does require experience. It does require actually being involved in the guts of examination and supervision. 

Second, in terms of priorities, again, it is certainly debatable 

what model you want to have, and a lot of countries around the 

world have debated it, but I don’t think that the existence of multiple banking regulators at the Federal level played a particularly 

important role in the genesis of this crisis. There are a lot of problems. There was a lot of blame to go around for a lot of reasons. 

But I don’t think it was the coexistence of the FDIC and the Comptroller that was a particular problem here. 

Senator CRAPO. Thank you. 

Ms. Matz. 

Ms. MATZ. The Administration proposal kept NCUA as an independent regulator, and we support that. 

Senator CRAPO. So you are willing to stick with that? 

Ms. MATZ. Yes. 

Senator CRAPO. All right. 

Mr. Ward. 

Mr. WARD. We think multiple viewpoints among the regulators 

fosters better decisionmaking and is a very healthy thing. We have 

a tremendous working relationship with the FDIC. We don’t always 

see eye-to-eye on our institutions, but that is a very healthy pressure among our examiners. 

Senator CRAPO. All right. 

Mr. Candon. 

Mr. CANDON. Thank you, Senator. I would second what Chairman Matz responded to your question. The President had recommended the NCUA be left out of the consolidation. Thank you. 

Senator CRAPO. All right. Thank you. 

Let me go back to you, Mr. Smith. As you indicated, you are very 

opposed to the consolidation. Mr. Dugan indicated that although 

one single regulator wouldn’t necessarily be the way you—if I am 

correctly representing you—would go, that we don’t really need 

four or five. What are your thoughts about that? Is there room for 

some consolidation? 

Mr. SMITH. Well, far be it from we poor State regulators to tell 

the Federal folks what to do with your territory. I think there could 

be consolidation, I guess, among the Federal agencies, but I will 

say we believe, and I agree with Governor Tarullo and Chairman 

Bair, that our relationships that we have with the Fed and the 

FDIC work very well, and we also agree with the Obama administration’s proposal to leave that alone and unimpaired. 

Senator CRAPO. All right. Thank you. 

I am going to shift gears and come back to you, Ms. Bair, and 

this really is a question on the resolution authority and the process 
19 

of resolution when a bank is seized or declared a failed bank. I recently have had a couple of those experiences in Idaho and I have 

had those who have been borrowers from the bank contact me to 

indicate that they really are not happy with the resolution authority. 

Just to give you an example, there are some who have contacted 

me who have indicated that they were in a position to repay much 

more than their particular loan ended up being auctioned for by 

the FDIC and that in that process, what happened was they were 

put in a bad situation because the loan was auctioned. The person 

or entity that purchased the loan immediately called it due. They 

were then put in a bind. The FDIC got 30 or 40 cents on the dollar. 

The one who really gained was the person who bought it at auction. The taxpayer didn’t win. The FDIC didn’t win. The borrower 

didn’t win. And the bank didn’t win. 

What is your reaction to that kind of an inquiry? 

Ms. BAIR. I do hear this a lot and I look into it when I hear it. 

I don’t know what the specific situation is you referred to, but I 

have found that, frequently, what has happened is a borrower may 

be wanting to get a bit of a deal. We are subject to least cost resolution, and although some reasonable price could perhaps be considered that would be better than what we would get if we auctioned the pool of loans off, other times, we have been approached 

by borrowers who just want a really low price for themselves—50 

or 60 cents on the dollar or lower. That is not something that we 

can justify under least cost. 

Also, sometimes they will say they want to buy their loan out, 

but they don’t have the cash resources to do it. So, when we ask 

for verification of their financial resources or who their new lender 

will be, they are not able to provide that. Sometimes the truth here 

is a bit more difficult than it may appear initially. 

Our policy is to offer borrowers the ability to buy back their loan 

if they offer a reasonable price and have the financial capability to 

do that. At my request, our ombudsman put together a Borrower 

Bill of Rights, which is on our website, and I would be happy to 

share with you and your staff, so that borrowers understand our 

process and what they can do. 

If the prices go too low, there is a question about least cost to 

our Fund, also. It is very difficult, given the volume that we have 

to do, to individually sell each of these loans, and at some point, 

you just have to market them in bulk. But, if a borrower is offering 

a reasonable price, has the financial capability and can show they 

can buy the loan back, we will sit down and accommodate them. 

Senator CRAPO. Thank you very much. 

Senator JOHNSON. Senator Merkley. 

Senator MERKLEY. Thank you very much, Mr. Chair. 

Chairman Bair, I wanted to go back to your testimony. You mentioned that you do not share your forecasts on the number of banks 

that might fail, and I can certainly understand that. Are you able 

to give us an order of magnitude? For example, in 2008 we had 25 

banks failing; in 2009, it is up to just shy of 100. Do we expect the 

next year to look more like 2008 or more like 2009? 

Ms. BAIR. It will look more like 2009. 

Senator MERKLEY. More like 2009. Thank you. 
20 

Chairman, community banks hold 11 percent of the industry assets, but 38 percent of small business and small farm loans. Since 

small business is a key driver of the economic recovery, would it 

be fair to say that recapitalizing community banks would be a 

smart way to get lending flowing back to Main Street? 

Ms. BAIR. We have been in discussions with Treasury for some 

time about making the TARP program work better for community 

banks. The 25 largest domestic institutions that qualified 100 percent participation in the TARP program. For the smaller institutions, it is about 9 percent. So, clearly, we think the program could 

be working better for the smaller institutions. 

In preparation for this testimony, I went back to look at small 

loan balances of larger and smaller institutions. Even though year 

over year, as of June 30th, small loan balances were down 1.9 percent overall, for the community banks, those less than $1 billion in 

assets, loan balances were up slightly over 2 percent. So community banks look like they are still in there trying to make these 

loans, but some additional capital support would be really helpful. 

Senator MERKLEY. Could you give us some sense of what that 

might look like? 

Ms. BAIR. While this is Treasury’s program, an idea that has 

been discussed is a dollar-for-dollar matching program. Right now 

the viability standard puts a lot of pressure on our examiners to 

try to identify the institutions that are, without the additional 

money, viable. Frankly, the ones that are clearly viable without the 

money do not want it. It is really the institutions where the decision is less clear that will come to us. But many times they are 

worthy, we think, and can raise significant private capital. So we 

have suggested a dollar-for-dollar matching program. This would 

provide an additional validation of viability from the market. The 

market may be willing to put additional capital in, help provide 

some additional protection to Treasury, and perhaps make the 

terms a little less onerous. This could perhaps be tied to increasing 

small business loans. 

So I think there are—and I know Senator Warner has had some 

thoughts on this—ways to approach this that would make the program work better for the smaller banks. 

Senator MERKLEY. Thank you. And would this have—did I see a 

hand raised there? Oh, no. Just scratching. OK. 

[Laughter.] 

Senator MERKLEY. At hearings and auctions, you have to be very 

careful how you are moving. 

In terms of the impact upon our commercial real estate, what are 

things that we can do to assist our community banks and, therefore, our small commercial real estate markets as we face a lot of 

balloon loans that will be coming due in the couple years ahead? 

Ms. BAIR. I think it is a problem. We are encouraging banks to 

work to restructure these loans. If they have a creditworthy borrower, a restructured loan with a lower payment, can make that 

a performing loan. We want them to do that. That preserves value, 

just the way it does with home mortgages. It is the same principle 

with commercial real estate. And we are in the process of finalizing 

guidance right now that makes that very clear and provides exam-
21 

ples to our examiners of what we consider prudent workouts. This 

should be encouraged, not criticized. 

In the near term that is the best we can do. Of course, bringing 

back the securitization market for commercial mortgages is going 

to be much more difficult. I know the Federal Reserve Board has 

been working on that, as has Treasury. But that is going to be a 

longer haul. 

Senator MERKLEY. One of the things I keep hearing back home 

in Oregon is from owners who have fully performed on their loans, 

but as their loans come up to be rolled over, the estimate of the 

value of their property has dropped enough that the bank is very 

nervous about reissuing it. 

Is there any form of guarantee that the Federal Government 

could do for, if you will, the difference in the drop in equity on 

loans that have been performing for the entire period to enable 

those banks to be able to meet the regulators’ requirements and at 

the same time be able to reissue those loans so we do not freeze 

up or seize up in those commercial markets? 

Ms. BAIR. I am unaware of any current programs that would do 

that. That is a new idea. I would just like to think about it. Others 

might want to have a comment. 

Senator MERKLEY. All right. Thank you very much. 

Senator JOHNSON. Senator Bunning. 

Senator BUNNING. Thank you, Mr. Chairman. 

This is for the primary regulators, though others may want to 

answer this question also. Do you have enough power to restrict 

the activities and risk taking of banks and holding companies? Do 

not be bashful. 

[Laughter.] 

Senator BUNNING. Usually you are not. 

Ms. BAIR. Well, for holding companies, no. I would defer to the 

holding company regulators down the aisle here. We have no authority over holding companies. 

Senator BUNNING. Well, you do have a lot of banks, though. 

Ms. BAIR. That we do. 

Mr. DUGAN. For the banks themselves, I think we do have adequate powers to restrict activities that we think are unsafe and unsound, but not the holding companies. Just the bank and the direct 

subsidiaries of the banks. 

Senator BUNNING. Fed? 

Mr. TARULLO. Senator, with respect to banks, I think on an ongoing basis, the answer is yes, although when it comes to closing an 

institution, we do not have the breadth of authority that the OCC 

or the FDIC has for the banks for which they are the primary Federal regulators. 

With respect to holding companies, there is, as you know, some 

lingering ambiguity from the Gramm-Leach-Bliley Act as to the 

reach of Federal Reserve authority over regulated subsidiaries. 

Senator BUNNING. On in the Fed’s mind. 

Mr. TARULLO. Well, Senator, I think it is in a number of people’s 

minds, and as we have said before, we would welcome clarification 

of that in any legislation that—— 

Senator BUNNING. We clarified that in 1994, but that has not 

been interpreted by the Fed. 
22 

Mr. TARULLO. If you look at the statute and the legislative history, there was some sense that there was supposed to be deference 

to functional regulators of subsidiaries. 

Senator BUNNING. Correct. And you were powered to write the 

regs and did not. 

Mr. TARULLO. Well, Senator, as you know, I cannot—— 

Senator BUNNING. I am not going to get into that dispute with 

you. 

Mr. TARULLO. OK. So let me just leave it there, though, with— 

I think with respect to the bank—— 

Senator BUNNING. Ms. Bair, would you like to comment about 

your ability to regulate the banks with the power that you now 

have? 

Ms. BAIR. There may be certain detailed areas, for instance, 

back-up authority, where through our good working relationships, 

we are able to effectively use it. Although, if we ever needed to 

bring an enforcement action with back-up authority, it is a fairly 

protracted process. 

Going forward as part of reform, we would like to see greater 

consistency in standards, particularly capital standards, between 

bank holding companies and banks. We think bank holding companies should be a source of strength for banks and should at least 

have as strong a capital level and quality of capital as the banks. 

There are a few areas where we would like to see some improvements, and that is not a secret. My fellow regulators know of our 

views on that. 

But, overall, I think the powers for both banks and bank holding 

companies have been pretty adequate, and perhaps there are areas 

where we could have used them better. Again, in terms of reform, 

looking at the disparities between the bank and the non-bank sector cannot be emphasized enough. As we try to improve the robust 

nature and quality of bank and bank holding company regulation, 

if there is still a giant shadow sector out there that is basically beyond the reach of meaningful prudential oversight, you are going 

to have the same problem that drove this crisis. Higher-risk activity will go into that shadow sector. 

Senator BUNNING. That is basically what I am asking. In other 

words, if there is a bank either that you are in charge of or the 

OCC or the holding companies, and they are doing things that you 

know that get them in trouble, can you stop it? 

Ms. BAIR. Yes. 

Mr. DUGAN. Yes. 

Senator BUNNING. You have enough power to stop it. 

Mr. DUGAN. Yes. 

Ms. BAIR. Yes. 

Senator BUNNING. The Fed also. 

Mr. TARULLO. Ultimately, yes. 

Senator BUNNING. Ultimately. OK. 

Why should firms that are supported by taxpayers’ guarantees 

and insured deposits and access to Fed windows be allowed to 

make huge profits on their own trading? What restrictions have 

you put on these activities? 

Mr. TARULLO. Well, Senator, the restrictions that would apply to 

the activities of subsidiaries of financial holding companies or bank 
23 

holding companies would be the capital liquidity and risk management restraints that would apply to any holding company, which 

is to say there is substantially less leverage permitted for such a 

company today than may have been the case before it became a 

bank holding company. And so that puts non-trivial constraints on 

what they can do. 

But under the structure of Gramm-Leach-Bliley, they are permitted to have subsidiaries that do engage in these trading activities so long as they conform to the capital and liquidity requirements. 

Senator BUNNING. If I have heard it once, I have heard it ten 

times, from not only the Secretary of the Treasury but the head of 

the Federal Reserve, that there are institutions in this country that 

are too big to fail. Too big to fail. 

Now, it is up to the people sitting at this desk or these all gathered here to stop that. I need suggestions. 

Mr. TARULLO. Well, I think Chairman Bair alluded earlier to 

something with which I certainly agree, that we need to have capital and other requirements that take full account of the additional 

risk that may be created by very large institutions. 

Senator BUNNING. The AIGs of the world. 

Mr. TARULLO. The AIGs of the world for certain, Senator. 

Senator BUNNING. OK. 

Ms. BAIR. Well, and as we have said before, we do think—— 

Senator BUNNING. I wanted to ask you one more question before 

you get away since I only have 25 seconds. Right now the FDIC 

is considering forcing banks to prepay their assessments for the 

next 3 years. I have two questions about this. 

First, earlier this year you asked Congress for a higher credit 

line at Treasury, and we gave it to you. Why didn’t you use that 

credit line? Is it really because Treasury has no room under the 

debt ceiling? 

Ms. BAIR. No, that is not the reason. We view the credit line as 

being there for emergencies for unexpected loss. Particularly, earlier this year, we thought it was very urgent to make sure we had 

plenty of breathing room there. 

But what we are talking about with the prepaid assessments for 

losses is different. 

Senator BUNNING. There is only one problem with that. The 

banks that have not put you in the problem are the very banks 

that are going to get assessed. 

Ms. BAIR. Well, the prepaid assessment is different from the special assessment. 

Senator BUNNING. I understand that, but they are the same 

banks. 

Ms. BAIR. They are the same banks, and at the end of the day, 

that is how insurance works. The lower risk banks end up generally to some level subsidizing the higher risk banks. 

Senator BUNNING. Let me finish this. Second, will that prepaid 

payment be enough to cover all the losses? Or will you have to 

raise more money again in the future? 

Ms. BAIR. Based on our current projections, that will be more 

than ample. But, again, a lot of this depends on the economy. So 
24 

if the economy has unforeseen troubles, that could be different. But 

based on current projections this year, yes. 

Senator BUNNING. I am only an economist, so I would tell you 

you’ve got a problem. 

Ms. BAIR. OK. 

Senator JOHNSON. Senator Tester. 

Senator TESTER. Thank you, Mr. Chairman. 

I want to step back a little bit, Chairwoman Bair, to what Senator Crapo was—just very quickly. You said that when it came to 

buying back loans per se, the borrowers were often given a chance 

to buy those loans back. How is the value of those determined? 

Ms. BAIR. It is difficult. Certainly if they just want to buy their 

loan back at what they owe—— 

Senator TESTER. At 100 percent—— 

Ms. BAIR. Right. Then that would be great. We would welcome 

that. Again, they need to demonstrate they actually have the ability to do that. 

If they want to have a discount, a couple of issues arise. If they 

have the capability to keep paying on the loans, if the loan is performing, the question becomes whether we should negotiate a deal 

for a borrower that is otherwise fully capable of making repayment 

on the loan. 

Even then, we do provide some flexibility, but we are required 

to pursue least-cost resolution, which means we need to get the 

best price for all the loans that we inherit in a receivership. Frequently just trying to do them one by one is not administratively 

practical and would get generally lower prices than if you market 

them all in bulk. 

Senator TESTER. Right. So seldom do you peel one loan out and 

sell it. 

Ms. BAIR. I can get you numbers of how often it happens. But, 

again, if they want to pay it off completely, we welcome that. Even 

below that, we will work with them. But frequently they are not 

able to. They say they want to, but they are not able to. 

Senator TESTER. OK. The deposit insurance fund, we have about 

what you are going to do in the short term. The Senator from Kentucky talked a little bit about the long term. Do you plan on permanently raising the rates on the long term, over the long term, to 

handle solvency in that fund? 

Ms. BAIR. Right. Well, we would bump up the rates by three 

basis points beginning in 2011. That would bring the base rate up 

to 15 to 19 basis points for most banks. That is still well below the 

23 basis points that was assessed on the industry during the S&L 

days. So as the economy recovers, as the banking sector heals, as 

our losses go down, we will constantly reassess that. We will stay 

within the range that Congress has prescribed, though I think perhaps Congress may want to think about giving us additional flexibility to build the fund up in good times. It is something that will 

be continuously monitored, but as of our projections now, we believe with the three-basis-point bump-up in 2011, we will be able 

to reestablish the fund and get it back to 1.15 within 8 years, 

which is what Congress has asked us to do. 

Senator TESTER. OK. Is there a point in time in which you permanently raise their rates? 
25 

Ms. BAIR. No, I do not think so. When the FDIC Board sets riskbased assessments, consideration is given to the risks in the banking system and the needs of the DIF to cover projected losses. 

Senator TESTER. This can be for Mr. Tarullo or Mr. Dugan. Actually, you can answer it, too, Ms. Bair. But there has been a lot of 

discussion about the make-up of systemic risk regulators and the 

powers entrusted to that body. I guess the question is—and, Mr. 

Smith, you may want to jump in on this, too. Do you believe there 

is a value in allowing representatives from State regulators to participate in the systemic risk regulator? 

Mr. TARULLO. Senator, I think it depends, as it often does, on 

how one conceives of what a systemic risk regulator is doing. I 

think there have been discrete functions which sometimes get 

lumped under that umbrella. 

What we have thought of in terms of the Federal Reserve’s role 

is consolidated supervision of systemically important institutions, 

and so it is very much a supervisory function, making sure that 

you are covering everybody who could pose a risk to the system. 

And in that context, of course, if there is a State bank, the State 

banking supervisor absolutely should be participating. 

A second context is thinking in terms of collective efforts to identify emerging risks and figure out what can be done, and there I 

think it is profitable to have people who see things from different 

parts of the financial system participating. 

Senator TESTER. OK. If there is a council of regulators, should 

the State regulators be represented? 

Mr. TARULLO. It depends, I think, Senator, on the functions of 

that council. If it is a matter of analysis and scrutiny and trying 

to coordinate, then I think there is a good case to be made for it. 

If it is a matter of actually making some binding Federal law decisions, then it probably is not. 

Senator TESTER. OK. Sheila, I have heard from banks that the 

FDIC is becoming more and more concerned about AG loans. Is 

that true? And I guess the question is why, even though the markets are in the tank. That probably answers it. 

Ms. BAIR. Not that I am aware of, Senator. We have been monitoring it for some time, but this is the second time in a week that 

somebody has asked for that so maybe I will probe a little more. 

[Laughter.] 

Ms. BAIR. But not that I am aware of, no. We are monitoring 

this. 

Senator TESTER. I appreciate that. 

Ms. BAIR. Senator, could I just go back to the borrower question? 

Senator TESTER. Go ahead. Sure. 

Ms. BAIR. One of the reasons we do whole bank transactions with 

loss share is if we can sell the whole bank, we do not run into this 

problem. A new bank gets those loans, services those loans, and it 

preserves the relationship with the borrower. It is only where we 

cannot do the whole bank transaction that we get into this problem. 

Senator TESTER. OK. Well, I understand. You are kind of between a rock and a hard place, quite honestly, because it does not 

seem quite fair to let somebody else make a bunch of dough on it 

when you could cut that—anyway, I do not want to go there. 
26 

Mr. Tarullo, there was a front-page story in the Wall Street Journal—we are going down a little different avenue here now—that 

talked about workers at the top 23 investment banks, hedge funds, 

asset managers, stock and commodity exchanges can expect to earn 

even more this year than they did in 2007, which was the peak 

year. I guess the question is, getting right to it: Are we returning 

to the attitude of greed that really occurred before the economic 

downturn—and that is being kind—in 2008? 

Mr. TARULLO. I do not know, Senator, that I can comment on 

what everybody else out there is thinking. I guess here is what I 

would say: 

First, I do have concerns sometimes in a variety of contexts that 

people in general, including in financial institutions, have not come 

to grips with the fact that things have changed. Things have 

changed in a basic way, and I think the presence of many of us at 

this table today promises that things are going to change more. 

That means business models. That means the way of assessing 

risk. That means how you run your institution. 

Second, with respect to the story itself, I do think that is a bit 

speculative, it is a bit projecting what is about to happen, and I 

think we should watch and see what, in fact, does happen and 

what, in fact, these firms are doing with their capital standards, 

which is ultimately of great importance to us. 

Senator TESTER. OK. If I might, Mr. Chairman, you know what 

the unemployment numbers. 

Mr. TARULLO. I do. 

Senator TESTER. And there are folks in many of these companies 

that are up here right now lobbying to make sure t there is no or 

very, very little regulation on a lot of the incidences that created 

the economic collapse. 

Do you find that some—because they are making a ton of dough. 

Do you find that somewhat ironic, troublesome? 

Mr. TARULLO. What I hope is that this Committee and the Congress as a whole will pass a strong set of reforms, no matter what 

other people out there are saying. 

Senator TESTER. OK. Thank you very much. 

Thank you, Mr. Chairman. 

Senator JOHNSON. Senator Gregg. 

Senator GREGG. Thank you, Mr. Chairman, and I want to thank 

the panel for their excellent testimony. It has been most interesting. 

First off, I want to congratulate the FDIC for deciding to forward-fund the fees. I think that is the right approach. You do a lot 

of things right. You have done a lot of things right during this 

problem. 

You did a lot of things right when I was Governor in 1989 in 

New Hampshire and five of our seven largest banks closed. Mr. 

Seidman came in and basically was our white knight. 

But you did say something that really concerns me, and that is, 

how you interpret the TARP, this idea that the TARP should be 

now used as a capital source for a lot of smaller banks that are 

having problems raising capital. I think all of you basically in your 

testimony have said we are past the massive systemic risk of a financial meltdown that would have caused a cataclysmic event. 
27 

TARP came about because of that massive potential cataclysmic 

event, and its purpose was to basically stabilize the financial markets and be used in that manner in order to accomplish that. As 

one of the authors, along with Senator Dodd—we sat through the 

negotiations of that—I think I am fairly familiar with that purpose. 

That was the goal. It should not now be used as a piggy bank for 

housing. It should not be used as a piggy bank for whatever the 

interest of the day is that can be somehow—it should not have 

been used for the automobile industry, and it really should not be 

used in order to have a continuum of capital available to smaller 

banks who have problems, in my opinion, because then you are just 

going to set up a new national program which will essentially undermine the forces of the market, and that would be a mistake. 

I did hear you say, Madam Chairman, that you expect $100 billion in losses. Is that a net number? Or do you expect to recoup 

some percentage of that? 

Ms. BAIR. No, that is what we project our losses to be over the 

next 5 years. 

Senator GREGG. So that is a net number after recoupment? 

Ms. BAIR. Yes. 

Senator GREGG. Well, is it—do you expect of that $100 billion in 

bad loans to be getting back 30 percent of—— 

Ms. BAIR. The $100 billion would be our losses. So let us say we 

had a 25-percent loss rate on our bank failures so far, so you would 

be talking about $400 billion in failed bank assets. 

Senator GREGG. Well, OK, so it—— 

Ms. BAIR. That is since the beginning of 2009, though. And, 

again, a lot of that has already been realized and reserved for. 

Senator GREGG. And you have got $64 billion, you said, or something, that has been realized and reserved against, so you have got 

about—— 

Ms. BAIR. That is right, yes. 

Senator GREGG.——$36 billion to go. OK. 

I have got a philosophical question here. If we look at this problem—granted, commercial real estate is now the problem, but commercial real estate, as I understand it from your testimony, is 

not—it is a serious problem. It is just not a systemic event. It is 

not going to cause a meltdown of our industries—of our financial 

industry. It may impact rather significantly especially the middlesized regional banks and some of the smaller banks, but it is not 

systemic. 

The systemic event was caused in large part in the banking industry by the primary residence lending activity—subprime, Alt-A, 

and regular loans. And all I heard about as the proposals for getting at this is regulatory upon regulatory layers to try to figure out 

a way to basically protect ourselves from having that type of excess 

in this arena occur again. 

But when you get down to it, it is all about underwriting. I 

mean, the bottom line is this is about underwriting. It is about 

somebody lent to somebody who either did not have the wherewithal to pay it back or who had an asset which was not worth 

what they lent on that asset. And probably the person who lent it 

did not really care because they were just getting the fee and they 

were going to sell it into the securitized market anyway. 
28 

So if you really want to get at this issue, wouldn’t it be more logical and simpler and—it is not the whole solution. Clearly, there 

has to be regulatory reform. But shouldn’t we look at the issue of 

having different underwriting standards, both of which the OCC 

and the FDIC have the authority over, in the area of what percentage to asset can you lend? You know, do you have to have 90 percent, 80 percent? Shouldn’t we have an underwriting standard that 

says you either get—that there is recourse? Shouldn’t we have underwriting standards that gives you the opportunity to either have 

an 80-percent or 90-percent choice or a covered loan, something 

like that? Isn’t that really a simpler way from a standpoint of not 

having—granted, it would chill the ability to get a house because 

people who could not afford to buy the house and could not afford 

to pay the loan back probably would not be able to get the loan. 

But isn’t that where we should really start this exercise, with recourse and 80 percent or 90 percent equity—10, 20 percent equity 

value and/or, alternatively, covered funds? I would ask everybody 

who actually is on the front lines of lending today. 

Ms. BAIR. Certainly underwriting is key, but poor underwriting 

is not necessarily the driver of future losses now. We are seeing 

loans go bad now that were good when they were made. But because of the economy—because people are losing their jobs, or retailers are having to close, or hotels cannot fill up—those loans are 

going bad. 

The economic dynamic is kicking in in terms of the credit distress that we are increasingly seeing on bank balance sheets. 

You are right, the subprime mortgage mess got started with very 

weak underwriting. It started in the non-bank sector. It spilled 

back into the banking sector. I think all of us wish we had acted 

sooner, but we did move to tighten underwriting standards, and 

strongly encouraged the Federal Reserve Board to impose rules 

across the board for both banks and non-banks. This, again, is the 

reason why you need to make sure that the stronger underwriting 

standards going forward apply to both banks and non-banks. 

Senator GREGG. Well, what should those underwriting standards 

be? 

Ms. BAIR. You should have to document income. You should do 

teaser-rate underwriting. The Federal Reserve Board has put a lot 

of these in effect now under the HOEPA rules. You have to document income. You cannot do payment shock loans. You have got to 

make sure the borrower can repay the loan if it is an adjustable 

rate mortgage that resets. These are just common-sense underwriting principles that have applied to banks for a long time. 

Senator GREGG. Or should there be recourse? 

Ms. BAIR. That has been a prerogative of the States. Some mortgage lending is recourse, some is non-recourse, depending on the 

State. 

Senator GREGG. Should there be a requirement that you cannot 

lend to 100 percent of value? 

Ms. BAIR. I think there is a strong correlation with loan-to-value 

ratios (LTVs). We actually recognize that in our capital standards 

that we are working on now. We would require a much higher risk 

weighting of loans which have high LTVs. So through capital 

charges, we are recognizing and trying to incent lower LTVs. 
29 

Senator GREGG. I am running out of time unfortunately. 

Mr. DUGAN. Senator, I think that you are onto a very important 

point that I do not think has gotten the same kind of attention that 

it deserved and what got us here in the mortgage market, not just 

in subprime. I think we lost our way as a country in terms of some 

of our basic underwriting standards on loan-to-value and on stated 

income, and I think it is worth exploring having a more common 

set of minimum underwriting standards that apply across the 

board with more specificity than what we have today, which I 

think is what you are suggesting. 

Mr. TARULLO. Senator, I think leverage on the expectation of rising asset prices was at the heart of the subprime problem, and indeed, it is at the heart of some of the other problems that we see, 

to some degree, in commercial real estate, as well. So, I would try 

to reinforce any instinct you have to push people toward better underwriting standards, and we, as the Chairman noted, are trying 

to do that ourselves. 

Mr. SMITH. I would only add, Senator, that in the most successful 

period I know of in home lending in the United States, there were 

mainly two, maybe three varieties of loans generally in the underwriting standards world, as you say. There was a requirement of 

a downpayment, for standard documentation, and the people that 

made the loans kept them. And on the basis of that lending experience, we projected—the magicians on Wall Street did projections 

about the loans that weren’t like that. 

So, I think there is—as you point out, the issue there is the issue 

of access to housing, and that is what it is. There is no free lunch 

and no easy answer. 

Senator GREGG. Thank you. Thank you very much for your testimony. 

Senator JOHNSON. Senator Bennet. 

Senator BENNET. Thank you, Mr. Chairman, and I would also 

like to thank the panel for your excellent testimony. 

Every weekend when I go home to Colorado, what I hear from 

small businesses is they have no access to capital, no access to 

credit, and we are in this, as the panel has talked about, in this 

remarkably difficult period where, on the one hand, the securitized 

market that blew up or imploded is now gone and has not been replaced, which is probably a good thing from a leverage point of 

view, but it hasn’t been replaced. 

On the other hand, we have got this looming commercial real estate issue that is still out there. And sort of caught in between all 

that are our small businesses who need access to capital in order 

to grow and in order to deal with the unemployment rate that Senator Tester talked about and sort of this folding back on top of 

itself. 

And I wondered, Mr. Tarullo, you mentioned in your testimony 

at the beginning your view that maybe some more direct efforts— 

I think you described it as temporary targeted programs—might be 

necessary to get our small businesses access to the credit that they 

need, and I wonder if you could elaborate a little bit more on that, 

because I suspect you are right. And in addition to that, I would 

ask to what extent we think the current accounting regimes are 
30 

ones that are either helping banks extend credit to small businesses or are intruding on their ability to do that. 

Mr. TARULLO. So, Senator, I don’t want to step on the prerogatives of the Congress, the Administration, various agencies that 

may have—— 

Senator BENNET. You can step on my prerogatives. I—— 

Mr. TARULLO.——but here is what I think. So what did we as a 

government, as a country, try to do with residential mortgages— 

not yet as successfully as I think many people would have wanted? 

We tried to do something about people losing their homes and to 

provide some mechanisms, some special mechanisms that would 

address those issues specifically, even as we all tried to put a foundation under the economy and get it growing again. 

And my thought was that something similar probably needs to 

be done in the small business arena, because I don’t think I hear 

as many of the stories as you do, but I hear enough of them, because I do try to get out and talk to borrowers as well as lenders. 

So, whether that is trying to streamline SBA lending and make the 

direct lending possibilities more real, or whether it is a new program which tries to provide guarantees, I don’t have a strong view 

on that and the Federal Reserve certainly has no view on it. But 

I do think that something targeted is going to be an important 

complement to the macro, bank regulatory, and TALF efforts that 

we have. 

Senator BENNET. Does anyone else have a view on that? Mr. 

Smith? 

Mr. SMITH. I would say in the absence of the type of a program 

of the type Governor Tarullo is talking about, it seems to me what 

clearly is needed is for small and medium-sized banks to clear up 

their balance sheet problems they have right now. I mean, the 

problems small businesses have in part are based on the fact that 

balance sheets have impaired real estate on them that has to be 

dealt with some way and that they have insufficient capital to 

make additional loans until that is cleared up. So until we work 

through—I mean, with all due respect to Senator Gregg, until the 

real estate, the follow-on problem of the commercial real estate 

problem for many of our banks is that it clogs up the balance 

sheets or impairs them in a way they can’t make loans. 

Senator BENNET. I guess I would ask, Chairman Bair, maybe you 

or Mr. Smith, to what extent—I mean, I am told that in the early 

1980s when we ran into trouble on agriculture, we did some things 

like stretch out the period of time that assets had to be marked 

down. And I don’t want to tread into this too much, but I wonder 

whether, given how serious the commercial real estate problem is, 

whether we are in a position to unclog the assets in a way that 

puts banks again in a position to be able to lend to small businesses. 

Ms. BAIR. You need to be careful, obviously. You want to provide 

flexibility to try to restructure the loans and accommodate borrowers in a way that preserves value but is fully disclosed. You 

don’t want to defer losses. If the losses are there, they need to be 

realized. There is this difficult balance. You would not want to go 

over to the regulatory forbearance situation, which I think did get 
31 

us in trouble during the S&L days. So, like anything, it is an important balance. 

I wish Senator Gregg was still here, because regarding the capital support for the smaller banks, the smaller banks are disproportionately a source of lending, particularly for small business. That 

is what they do. They do small business lending. They do commercial real estate. I am not normally an advocate for government support programs, but I do think the tremendous disparities in TARP 

between the 25 largest banks, with 100 percent participation, and 

for the smaller banks, less than 9 percent participation has created 

competitive disparities between large and small institutions—between the too-big-to-fail institutions where funding costs are going 

down, and the smaller institutions where funding costs are going 

up. 

Again, with a matching program that provides market validation 

that an institution is viable, markets are more willing to put more 

capital in. Additional capital could help balance-sheet capacity to 

enable more of this type of lending by the smaller banks. 

Ms. MATZ. Senator, I just wanted to make the point that credit 

unions make loans to small businesses, or club member business 

lending, and the average loan is only about $170,000. So they really are targeted to small businesses. In the current year, the lending 

is up almost $2 billion. Last year, it was up $5 billion. So, more 

and more, credit unions are making more and more loans to small 

businesses. 

Senator BENNET. Thank you, Mr. Chairman. 

Senator JOHNSON. Senator Corker. 

Senator CORKER. Mr. Chairman, thank you, and as always, I 

thank each of you for your testimony. I always learn something 

when you are here. 

I also wish Senator Gregg was here. I think we share some of 

the same intuitions and concerns, and while you know I respect the 

FDIC and your leadership very much, I tend to hear regulators 

talking about them wanting assistance to the banks that they have 

liabilities to. I know Chairman Dugan, who I also respect greatly, 

very much appreciated the TARP assistance to the banks that he 

regulated so they wouldn’t fail, and now you very much would like 

TARP assistance to the banks that you have depositor worries 

with. I just hate to hear us move into that mode, and again, I respect you both very, very much and have worked with you on lots 

of legislation. I do hate hearing that kind of thing. 

Chairman Bair, I know you mentioned the underwriting wasn’t 

really the issue because loans were underwritten well in the past 

today are problems. But again, I think that was driven by the fact 

that we had poor underwriting in the beginning and it created a 

financial system issue that has really put us into this situation. So, 

I do think those are very much tied together. 

I will have to say that as we have looked at the regulatory reforms, it seems like we are just sort of rearranging the deck chairs. 

I mean, the issue has been always real estate in modern times. As 

we have had financial crises, it has always been real estate. I 

haven’t heard anything in the regulatory reform—I know we talk 

about capital requirements, but the kinds of losses we have had, 

we would have blown through those capital requirements you all 
32 

are talking about very, very quickly. We still would have needed 

a systemic bailout or some kind of mechanism. So, to me, that is 

not it. 

I know that we talked a little bit gratuitously about maybe we 

ought to put that in regulation—I mean, in laws. I can’t imagine 

us writing laws up here that talk about what the equity ought to 

be in homes and those kind of things. You all don’t really want us 

to do that, do you? 

So, it seems to me that actually the Fed is supposed to put out 

that type of guidance, is that correct? 

Mr. TARULLO. That is correct, Senator, and we have now, yes. 

Senator CORKER. So you are sending out guidance—— 

Mr. TARULLO. Well, there is—— 

Senator CORKER.——that says that loans, you have to have 20 

percent down payment—— 

Mr. TARULLO. This is on the consumer protection side. One of the 

needs to underwrite is to make sure that you are going to make 

an assessment based on the ability of the borrower to pay, not just 

on the rising value of the real estate, for example. 

Mr. DUGAN. But, Senator, more generally, it is not just the Fed. 

All of us—— 

Mr. TARULLO. Right. When it comes to safety and soundness, 

every regulator—— 

Senator CORKER. I mean, I think it would be wonderful. Let us 

face it. In the desire for policymakers to make sure people at every 

income level led the life of middle-class citizens, we promoted loan 

making that helped destroy our system. That wasn’t the whole picture, but that certainly was a part of it. Are each of you as regulators saying that you are going to put out strong standards that 

really counter policymakers’ desire to make sure that everybody in 

America has a home and a ham in their pot? Is that basically what 

you are saying you are going to do, because I think that is the only 

way, by the way, we are going to keep this from happening again, 

is it not? 

Mr. TARULLO. I think, as Chairman Bair said a little while ago— 

she didn’t say it quite in these words, but what I heard her say 

was, we have got to worry about problems in the future as well as 

problems in the past. I do think that the problems with underwriting played a very central, though not the only role, in the financial crisis. I do think we need underwriting standards for residential mortgages and in other areas—— 

Senator CORKER. And each of you can write those, is that correct? 

Mr. DUGAN. Yes. 

Senator CORKER. And are each of you going to write standards 

that are dramatically different from those that got us into the situation? I mean, each of you agreed with Senator Gregg’s questions, 

but I wonder if we are actually going to take action to make that 

occur. 

Ms. BAIR. First of all, I want to clarify, there is plenty of bad underwriting. I want to emphasize that, the kinds of new credit problems we are seeing now are more economically driven. There was 

plenty of bad underwriting in both mortgage lending as well as 

commercial real estate. 
33 

We have tightened the standards tremendously. I think we are 

being criticized in other quarters. Please note that we issued commercial real estate guidance in 2006. 

Senator CORKER. Well, I—— 

Ms. BAIR. The Federal Reserve Board has issued rules that apply 

to both banks and non-banks for mortgage lending that significantly tighten the standards. That already has taken place. Also, 

we are working on capital rules that will require greater capital 

charges against higher-risk loans, such as those with high LTVs. 

The bank regulators are doing all that, and have for some time. 

You still have a fairly significant non-bank sector, one that can 

come back as the capital markets heal. That is why I hope that, 

going forward, in terms of whatever reforms you come up with, 

that those reforms will reflect the fact that there are two different 

sectors, two different providers of credit in this country. We can 

keep tamping down on the banks as we have been. But if the nonbank sector is left, by and large, unregulated, that is not going to 

fix the problem. 

Mr. DUGAN. And Senator, if I could just add, if you look at the 

experience of Canada where they are our neighbors and have a 

much more conservative standard for underwriting, where they 

verify income and have loan-to-value ratios that are higher, you 

can’t get a 30-year fixed-rate mortgage, but they have very high 

levels of home ownership and they didn’t have any of these problems. So, they have more of a system that has a basic minimum 

that cuts across the board. It may not be the right ones for us, but 

I definitely think it is worth exploring. 

Senator CORKER. And I would really like—I know that I am 

going to run out of time here and we are not going to be able to— 

but we talk often, I know, all of us—I would really like to see what 

it is we need to do on our end. I don’t think we as a country have 

the political will to do the things we need to do to make sure that 

this doesn’t happen again. I absolutely do not see it. I mean, this 

regulatory reform, again, is just moving chairs around. It is not 

changing anything about the way that we go about doing this business. And I hope that as we move along, you all will help with that. 

Mr. Tarullo, again, I thank you for your testimony, also, as always. I am wondering, on 13(3), as we move into regulation, should 

we—I mean, in essence, we are going to be talking about TARP 

and resolution and all of those kind of things down the road, but 

on the 13(3) issue, exigent circumstances, should we move to narrow the Fed’s ability to use 13(3) for specific institutions, move 

away from that so that your assistance is at the system level, but 

where you are not specifically—I mean, in essence, you can get 

around—I know that some people here support the Administration’s proposal to sort of codify TARP. I don’t. I think we should 

end TARP at the end of the year. But it seems to me that under 

13(3), the way you now have it, you all can work around that at 

the Fed and, in essence, do the same thing at specific institutions, 

and I am wondering if you feel we ought to limit that. 

Mr. TARULLO. So, I would say, Senator, that I think most people 

at the Federal Reserve would be happy if they were not in the position where people came to us when there was a need for resolving 

or dealing with a specific financial institution, but I do think one 
34 

needs to have a mechanism, a mechanism in law by which some 

part of the government can deal with the large financial institution 

that may be in distress. 

And that is why I think all three of us, certainly, have supported 

moving forward with a resolution mechanism that would cover the 

large financial institutions. I do think within the context of that, 

you have to address the question of potential funding streams for 

short-term liabilities or the sort. So, I think it needs to be addressed somewhere. It doesn’t need to be in 13(3). 

Senator CORKER. If I am hearing you properly, if we had a resolution mechanism in place, which we did not have for complex bank 

holding companies and others, like AIG, which is not one of those— 

if we had a resolution mechanism that was defined and we had the 

ability to fund the short term, while you are resolving that, hopefully not in conservatorship but in receivership, where you are putting them out of business, in essence, we could narrow the abilities 

of the Fed and also not support the Administration’s proposal for 

Treasury to hold unto itself the ability to put taxpayer money into 

various entities they feel might pose systemic risk. We could do 

away with that if we had an appropriate resolution mechanism. 

Mr. TARULLO. Well, I think you do need a mechanism that can 

provide, in appropriate circumstances, for the sort of assistance 

that might be needed, and if you have that, it doesn’t need to be 

done through 13(3), and as I said, I think the Federal Reserve 

would prefer that it not be done through 13(3). 

Senator CORKER. And you are perfectly satisfied we are resolving 

them out of existence? You are not talking about that assistance 

to conserve an institution? 

Mr. TARULLO. Well, I think—so, Senator, that is probably one of 

the open questions, and exactly what do we mean, I think there 

is—I think what is important is that there be real prospects of 

losses for shareholders and creditors when their large institution 

gets in that circumstance. 

Senator CORKER. Mr. Chairman, I thank you, and I am sorry we 

didn’t get to each of you. I do hope that what we are doing with 

the smaller banks, that some assistance was being sought through 

TARP here earlier, I hope that we are encouraging them, while 

they can, those who can, to raise capital. I have seen this taking 

place now and shareholders are being deluded and we are going 

ahead and raising the capital necessary to weather this storm. 

I thank each of you and I look forward to seeing you again soon. 

Senator JOHNSON. Senator Schumer. 

Senator SCHUMER. Thank you, Mr. Chairman. I want to thank 

you for holding this hearing. I thank the witnesses. 

I would like to talk a little bit about fees and consumer protection, Consumer Protection Agency. Many of the banks we know 

have reacted to lost profits from their mortgage problems by raising fees on consumers, one of which is overdraft fees. There is no 

transparency. They don’t give consumers a real chance to decide if 

they want—even want this kind of protection. Banks raked in about $24 billion in overdraft fees last year. That 

was up 35 percent from the year before. That ought to stick out. 

Even accounting for higher debit card use, a worsening credit environment due to the economy, that is a massive increase. It indi-
35 

cates to me that consumers are bearing a disproportionate burden 

in maintaining the health of many banks’ balance sheets. 

They are also raising ATM fees, as you know. Bank of America 

recent raised its fee for other bank customers to $3. That would 

have been unheard of a few years ago. Maybe one of these fly bynight machines would have done that, but not a major bank. And 

the average cost of an ATM transaction is also now over $3. 

Even if you withdraw $100, that is a high fee in percentage 

terms, and, of course, the overdraft fees, you buy a $2 cup of coffee 

and they charge you $35 without even telling you. It makes your 

blood boil. 

So, my question is this. This is to really to Comptroller Dugan, 

Mr. Ward. As regulators, you are responsible for not only safety 

and soundness, but consumer protections. Maybe Mr. Tarullo also 

has a role here. What are you doing to ensure that consumers don’t 

bear the brunt of banks’ efforts to repair balance sheets, particularly in these two instances? 

Mr. DUGAN. On the area of overdraft fees, we actually don’t have 

the rulemaking authority in that area. The Federal Reserve has 

that authority. They currently have a proposal that is out. We also 

don’t have authority to write rules for unfair and deceptive practices. We have done, as regulators—— 

Senator SCHUMER. Don’t you have general authority on consumer-type issues? Not at all? 

Mr. DUGAN. Not on general fee regulation. Either it is mostly disclosure-based that is set by rules promulgated by others, or if it 

gets to a point where it is unfair and deceptive, yes. And in answer—— 

Senator SCHUMER. Don’t you think these are unfair and deceptive—— 

Mr. DUGAN. I think that it is absolutely the case that consumers 

should be given the right to opt in—to have a choice about whether 

to participate in these programs or not. 

Senator SCHUMER. But, Mr. Dugan, if you decided that these 

were unfair and deceptive, which I think average people hearing 

about these, they are deceptive because you don’t know, they are 

unfair because they are so high, you could do something. 

Mr. DUGAN. And I think that the proposal that the Federal Reserve has put out that has not yet been adopted does address the 

question of consent to these programs, which is critically important. 

Senator SCHUMER. OK, the Fed, tell us what you are doing. 

Mr. TARULLO. That is correct, Senator. We have a proposal that 

we are working on right now which would go right to the heart of 

the issue of opt in/opt out. And although I can’t obviously prejudge 

what the Board will do, I expect that within the next month, that 

is going to come up for consideration—— 

Senator SCHUMER. Has that been made public, that proposal? 

Mr. TARULLO. Yes. That has been made public. 

Senator SCHUMER. OK. And what does it do, specifically? 

Mr. TARULLO. This would provide for the ability of a consumer 

to know that he or she was opting into a program like this and to 

understand the terms under which—— 
36 

Senator SCHUMER. It would let the consumer know at the 

time—— 

Mr. TARULLO. Yes. 

Senator SCHUMER.——that they are in overdraft status and—— 

Mr. TARULLO. That is actually more difficult technically, and that 

is some of what is out for comment right now. 

Senator SCHUMER. Well, they used to do that all the time. 

Mr. TARULLO. But that is—— 

Senator SCHUMER. It would not honor the request because you 

didn’t have the money. 

Mr. TARULLO. Right, and with the advent of technologies like 

debit cards, for example, it becomes more complicated than it was 

before. But that is one of the things that is out for comment and 

consideration right now, is how this might be done. 

Senator SCHUMER. OK. When did you start working on this proposal? 

Mr. TARULLO. Let me see. I actually don’t—— 

Senator SCHUMER. Not only you, but—— 

Mr. TARULLO. I don’t know when the staff started working on it, 

Senator, and I will have to get back to you on that. I first became 

aware of it a couple of months ago. 

Senator SCHUMER. Right. OK. And what about on the other issue 

that I mentioned? 

Mr. TARULLO. On the fees issue? 

Senator SCHUMER. Yes. 

Mr. TARULLO. So, I don’t think we have a current rulemaking on 

ATM fees. That has been an issue in the past, so I would have 

to—— 

Senator SCHUMER. Do you think $3 is excessive? 

Mr. TARULLO. Well, I think—again, there—— 

Senator SCHUMER. Well, let me ask you another question. Has 

the cost from 2 years ago to now gone up so that it would merit 

a large increase in the fee? 

Mr. TARULLO. Well, I doubt that the cost has gone up very much, 

and so the question, as with all fees, becomes the degree to which 

an institution ought to be able to make that judgment if it is fully 

disclosed or not. 

Senator SCHUMER. OK. As you know, I think the Fed does a good 

job in many areas, but in consumer protection, I don’t think the 

regulatory agencies have done a good job, and here is—I mean, 

maybe this is a little rhetorical. It is to me, but I am going to let 

you guys answer it. I mean, isn’t what we have just heard a good 

reason that we need a strong, independent agency to protect the interests of consumers, separate and apart from safety and soundness regulators? 

Mr. TARULLO. Umm—— 

Senator SCHUMER. I mean, I have found that in the consumer 

area, the Fed and the OCC doesn’t do much, although I think they 

have the power to do some things. It is slow. Still in the back of 

their mind is the idea of safety and soundness and bank balance 

sheets. And the consumer doesn’t get all the protection he or she 

deserves. It is one of the reasons I believe the agency that Senator 

Dodd is proposing, and original Senator Durbin and I proposed, a 

Consumer Financial-Consumer Product Safety Commission, is so 
37 

needed. Also, they are able to deal with new issues as they come 

up. They don’t—I suppose Mr. Dugan would have to go into rulemaking and say what is unfair, what is deceptive, and they would 

figure out a way around that. 

Why wouldn’t it be better to have these myriad of issues—and 

our financial institutions are getting better and better at coming up 

with new ways to make fees—why isn’t it better to have an agency 

exclusively devoted to that doing the job as opposed to a regulator 

which has many other important jobs to do to deal with? I would 

ask both Mr. Tarullo and Mr. Dugan, and then anyone else who 

would want to comment. 

Mr. DUGAN. Sure. 

Mr. TARULLO. Senator, as I think you know, the Federal Reserve, 

as a Board, has no position one way or the other on creation of the 

CFPA, but I would make the following observations. First, I think 

there are undoubted merits to having a single Consumer Protection 

Agency whose sole focus is on that function. 

Second, though, you will lose something if you do it. You will lose 

some of the combination of understanding of safety and soundness 

and consumer protection. I think there is a risk. This has not necessarily happened, but there is a risk that sometimes the impact 

on credit availability won’t be fully understood. These are things 

that can be addressed, but I think that there would be costs. 

A third point is, as you probably also know, prior to my joining 

the Federal Reserve Board in January, I was quite critical of the 

failure of the bank regulatory agencies generally to engage in 

enough consumer protection on subprime, on credit cards, and 

many other things. I will say, though, that I think in the last few 

years, Chairman Bernanke has set a tone at the Fed which has 

been one of looking for vigorous consumer protection and that the 

rules on credit cards and the rules on home mortgages are evidence 

of that. It may not be everything you think that needs to be done, 

but I think it has been done. 

Senator SCHUMER. Chairman Dugan? 

Mr. DUGAN. Senator, I think there are two very powerful—— 

Senator SCHUMER. Comptroller Dugan. 

Mr. DUGAN. Comptroller. That is OK. There are two very good 

and powerful ideas connected with the CFPA. One is to have common rules that apply to everybody, whether you are a bank or a 

non-bank, and to have strong authority to do that. So I think that 

is important. 

Second, I think the part of the system that had the least attention paid to it were the non-banks in terms of how rules are implemented. You don’t have the comprehensive regime today. So that 

part, I think, can be a very good and powerful idea. 

The part that I have had concerns about is implementing those 

rules on banks and carrying them out through supervision, examination, and enforcement. I think that should stay with the bank 

regulators. I think that you do get a benefit from things that are 

interwoven together between consumer protection and safety and 

soundness, like underwriting standards in subprime mortgages, 

which are related to consumer protection issues. We see examples 

of it all the time, which I provided to the Committee in our last 

testimony. That is the part I would worry about. 
38 

And then, second, the notion that the new agency should focus 

its implementation responsibilities on the non-banks, again, very 

powerful idea. 

Senator SCHUMER. Would you just—I know my time has expired, 

Mr. Chairman—in retrospect, do you think the regulatory agencies, 

not yours in particular, but including yours—have done as vigorous 

a job on consumer protection as they should have? 

Mr. DUGAN. I—— 

Senator SCHUMER. In the areas that you have jurisdiction over, 

not the non-banks. 

Mr. DUGAN. Well, again, you have to sort of go area by area, but 

in some places, no. Other places, yes, which I think are not recognized. And I do think there has been the systemic problem that we 

only have a part of the pie and there is a big chunk of it that no 

one is looking at. 

Senator SCHUMER. No, that is true. That is one argument for it. 

Do you agree? Mr. Tarullo, how about you? Do you think your 

agency and all of the agencies have done as good a job as they 

should have on consumer protection? 

Mr. TARULLO. Senator, I am on record saying it, so I will say it 

again. I don’t think the agencies, including the Federal Reserve, 

did a good enough job. 

Senator SCHUMER. Thank you. Thanks, Mr. Chairman. 

Senator JOHNSON. I want to thank the witnesses once again for 

being here today. I look forward to working with the members of 

the Banking Committee as we continue to consider measures to 

stabilize the banking sector and our economy as a whole. 

This hearing is adjourned. 

[Whereupon, at 4:29 p.m., the hearing was adjourned.] 

[Prepared statements and responses to written questions follow:] 
39 

PREPARED STATEMENT OF SENATOR TIM JOHNSON 

As Congress and this Committee continue its work to stabilize financial institutions and promote our nation’s economic recovery, I have called this hearing today 

for regulators to give us an update on the current conditions of the financial institutions in our country. It is vital that we know what continuing challenges and concerns our nation’s institutions face. Specifically, I continue to be concerned about the 

lending environment, particularly for small businesses, the capital needs of institutions, and the impact of commercial real estate and other loan portfolios on institutions’ balance sheets. In addition, while many of the large banks in our country 

have stabilized, the FDIC’s list of troubled banks, many of them small community 

banks, is growing. 

While restructuring our nation’s regulatory system is this Committee’s top priority, I don’t think we can do that without a clear understanding of what is happening within the sector. Concerns and problems within individual financial institutions will still exist even with a new regulatory structure unless they are addressed 

as well. Continuing to ensure the safety and soundness of viable institutions and 

the overall financial stability of our nation’s economy is vital to protecting all Americans’ pocketbooks, savings and retirement. 

I want to thank the witnesses for being here today, and I look forward to hearing 

from each of you regarding any developing trends or concerns within the banking 

industry or throughout the economy, and to hear of the regulatory or supervisory 

steps your agencies are taking to respond to these challenges. 

PREPARED STATEMENT OF SENATOR MIKE CRAPO 

Thank you, Mr. Chairman, for holding this hearing to examine the state of the 

banking and credit union industry. 

Failures of small banks continue to grow and key trouble spots are looming, such 

as commercial real estate loans. According to a recent New York Times article, 

about $870 billion, or roughly half of the industry’s $1.8 trillion of commercial real 

estate loans, now sit on the balance sheet of small and medium sized banks. I am 

interested in learning to what extent has the Term Asset-Backed Securities Loan 

Facility (TALF) encouraged capital to enter the commercial real estate market and 

what other steps should regulators take to address this problem. 

Many community banks and credit unions have tried to fill the lending gap 

caused by the credit crisis. Even with these efforts, it is apparent that many consumers and small businesses are not receiving the lending they need to refinance 

their home loan, extend their business line of credit, or receive capital for new business opportunities. Regulators need to be mindful that they strike the appropriate 

balance to bolster capital and meet the credit needs of our economy. FASB’s new 

rules on off-balance sheets will create challenges on this point. 

As we began to explore options to modernize our financial regulatory structure, 

it is important that our new structure allows financial institutions to play an essential role in the U.S. economy by providing a means for consumers and businesses 

to save for the future, to protect and hedge against risk, and promote lending opportunities. 

Again, I thank the Chairman for holding this hearing and I look forward to working with him and other Senators on these and other issues. 

PREPARED STATEMENT OF SHEILA C. BAIR 

CHAIRMAN, FEDERAL DEPOSIT INSURANCE CORPORATION

OCTOBER 14, 2009 

Chairman Johnson, Ranking Member Crapo and members of the Subcommittee, 

I appreciate the opportunity to testify on behalf of the Federal Deposit Insurance 

Corporation (FDIC) regarding the condition of FDIC-insured institutions and the deposit insurance fund (DIF). While challenges remain, evidence is building that financial markets are stabilizing and the American economy is starting to grow again. 

As promising as these developments are, the fact is that bank performance typically 

lags behind economic recovery and this cycle is no exception. Regardless of whatever 

challenges still lie ahead, the FDIC will continue protecting insured depositors as 

we have for over 75 years. 

The FDIC released its comprehensive summary of second quarter 2009 financial 

results for all FDIC-insured institutions on August 27. The FDIC’s Quarterly Banking Profile provided evidence that the difficult and necessary process of recognizing 
40 

1Sources: Moody’s Economy.com (borrowers ‘‘underwater’’) and FDIC estimate based upon 

Mortgage Bankers Association, National Delinquency Survey, second quarter 2009 (number of 

foreclosures). 

loan losses and cleaning up balance sheets continues to be reflected in the industry’s 

bottom line. As a result, the number of problem institutions increased significantly 

during the quarter. We expect the numbers of problem institutions to increase and 

bank failures to remain high for the next several quarters. 

My testimony today will review the financial performance of FDIC-insured institutions and highlight some of the most significant risks that the industry faces. In 

addition, I will discuss the steps that we are taking through supervisory and resolutions processes to address risks and to reduce costs from failures. Finally, I will 

summarize the condition of the DIF and the recent steps that we have taken to 

strengthen the FDIC’s cash position. 

Economy 

In the wake of the financial crisis of last Fall and the longest and deepest recession since the 1930s, the U.S. economy appears to be growing once again. Through 

August, the index of leading economic indicators had risen for five consecutive 

months. Consensus forecasts call for the economy to grow at a rate of 2.4 percent 

or higher in both the third and fourth quarters. While this relative improvement 

in economic conditions appears to represent a turning point in the business cycle, 

the road to full recovery will be a long one that poses additional challenges for 

FDIC-insured institutions. 

While we are encouraged by recent indications of the beginnings of an economic 

recovery, growth may still lag behind historical norms. There are several reasons 

why the recovery may be less robust than was the case in the past. Most important 

are the dislocations that have occurred in the balance sheets of the household sector 

and the financial sector, which will take time to repair. Households have experienced a net loss of over $12 trillion in net worth during 

the past 7 quarters, which amounts to almost 19 percent of their net worth at the 

beginning of the period. Not only is the size of this wealth loss unprecedented in 

our modern history, but it also has been spread widely among households to the extent that it involves declines in home values. By some measures, the average price 

of a U.S. home has declined by more than 30 percent since mid-2006. Home price 

declines have left an estimated 16 million mortgage borrowers ‘‘underwater’’ and 

have contributed to an historic rise in the number of foreclosures, which reached 

almost 1.5 million in just the first half of 2009.1

Household financial distress has been exacerbated by high unemployment. Employers have cut some 7.2 million jobs since the start of the recession, leaving over 

15 million people unemployed and pushing even more people out of the official labor 

force. The unemployment rate now stands at a 26-year high of 9.8 percent, and may 

go higher, even in an expanding economy, while discouraged workers re-enter the 

labor force. 

In response to these disruptions to wealth and income, U.S. households have 

begun to save more out of current income. The personal savings rate, which had 

dipped to as low as 1.2 percent in the third quarter of 2005, rose to 4.9 percent as 

of second quarter 2009 and could go even higher over the next few years as households continue to repair their balance sheets. Other things being equal, this trend 

is likely to restrain growth in consumer spending, which currently makes up more 

than 70 percent of net GDP. 

Financial sector balance sheets also have undergone historic distress in the recent 

financial crisis and recession. Most notably, we have seen extraordinary government 

interventions necessary to stabilize several large financial institutions, and now as 

the credit crisis takes its toll on the real economy, a marked increase in the failure 

rate of smaller FDIC-insured institutions. Following a 5-year period during which 

only ten FDIC-insured institutions failed, there were 25 failures in 2008 and another 98 failures so far in 2009. 

In all, FDIC-insured institutions have set aside just over $338 billion in provisions 

for loan losses during the past six quarters, an amount that is about four times larger than their provisions during the prior six quarter period. While banks and thrifts 

are now well along in the process of loss recognition and balance sheet repair, the 

process will continue well into next year, especially for commercial real estate 

(CRE). 

Recent evidence points toward a gradual normalization of credit market conditions 

amid still-elevated levels of problem loans. We meet today just 1 year after the historic liquidity crisis in global financial markets that prompted an unprecedented response on the part of governments around the world. In part as a result of the 
41 

2Source: Mortgage Bankers Association, National Delinquency Survey, Second Quarter 2009. 3 Noncurrent loans are loans 90 or more days past due or in nonaccrual status. 

Treasury’s Troubled Asset Relief Program (TARP), the Federal Reserve’s extensive 

lending programs, and the FDIC’s Temporary Liquidity Guarantee Program (TLGP), 

financial market interest rate spreads have retreated from highs established at the 

height of the crisis last Fall and activity in interbank lending and corporate bond 

markets has increased. 

However, while these programs have played an important role in mitigating the 

liquidity crisis that emerged at that time, it is important that they be rolled back 

in a timely manner once financial market activity returns to normal. The FDIC 

Board recently proposed a plan to phaseout the debt guarantee component of the 

Temporary Liquidity Guarantee Program (TLGP) on October 31st. This will represent an important step toward putting our financial markets and institutions back 

on a self-sustaining basis. And even while we seek to end the various programs that 

were effective in addressing the liquidity crisis, we also recognize that we may need 

to redirect our efforts to help meet the credit needs of household and small business 

borrowers. 

For now, securitization markets for government-guaranteed debt are functioning 

normally, but private securitization markets remain largely shut down. During the 

first 7 months of 2009, $1.2 trillion in agency mortgage-backed securities were 

issued in comparison to just $9 billion in private mortgage-backed securities. 

Issuance of other types of private asset-backed securities (ABS) also remains weak. 

ABS issuance totaled only $118 billion during the first 9 months of 2009 in comparison to $136 billion during the first 9 months of 2008 and peak annual issuance of 

$754 billion in 2006. 

Significant credit distress persists in the wake of the recession, and has now 

spread well beyond nonprime mortgages. U.S. mortgage delinquency and foreclosure 

rates also reached new historic highs in second quarter of 2009 when almost 8 percent of all mortgages were seriously delinquent. In addition, during the same period, 

foreclosure actions were started on over 1 percent of loans outstanding.2 Consumer 

loan defaults continue to rise, both in number and as a percent of outstanding loans, 

although the number of new delinquencies now appears to be tapering off. Commercial loan portfolios are also experiencing elevated levels of problem loans which industry analysts suggest will peak in late 2009 or early 2010. 

Recent Financial Performance of FDIC–Insured Institutions 

The high level of distressed assets is reflected in the weak financial performance 

of FDIC-insured institutions. FDIC-insured institutions reported an aggregate net 

loss of $3.7 billion in second quarter 2009. The loss was primarily due to increased 

expenses for bad loans, higher noninterest expenses and a one-time loss related to 

revaluation of assets that were previously reported off-balance sheet. Commercial 

banks and savings institutions added $67 billion to their reserves against loan 

losses during the quarter. As the industry has taken loss provisions at a rapid pace, 

the industry’s allowance for loan and lease losses has risen to 2.77 percent of total 

loans and leases, the highest level for this ratio since at least 1984. However, noncurrent loans have been growing at a faster rate than loan loss reserves, and the 

industry’s coverage ratio (the allowance for loan and lease losses divided by total 

noncurrent loans) has fallen to its lowest level since the third quarter of 1991.3

Insured institutions saw some improvement in net interest margins in the quarter. Funding costs fell more rapidly than asset yields in the current low interest rate 

environment, and margins improved in the quarter for all size groups. Nevertheless, 

second quarter interest income was 2.3 percent lower than in the first quarter and 

15.9 percent lower than a year ago, as the volume of earning assets fell for the second consecutive quarter. Industry noninterest income fell by 1.8 percent compared 

to the first quarter. 

Credit quality worsened in the second quarter by almost all measures. The share 

of loans and leases that were noncurrent rose to 4.35 percent, the highest it has 

been since the data were first reported. Increases in noncurrent loans were led by 

1-to-4 family residential mortgages, real estate construction and development loans, 

and loans secured by nonfarm nonresidential real estate loans. However, the rate 

of increase in noncurrent loans may be slowing, as the second-quarter increase in 

noncurrent loans was about one-third smaller than the volume of noncurrent loans 

added in first quarter. The amount of loans past-due 30–89 days was also smaller 

at the end of the second quarter than in the first quarter. Net charge-off rates rose 

to record highs in the second quarter, as FDIC-insured institutions continued to recognize losses in the loan portfolios. Other real estate owned (ORE) increased 79.7 

percent from a year ago. 
42 

4Defined as commercial and industrial loans or commercial real estate loans under $1 million 

or farm loans less than $500,000. 

Many insured institutions have responded to stresses in the economy by raising 

and conserving capital, some as a result of regulatory reviews. Equity capital increased by $32.5 billion (2.4 percent) in the quarter. Treasury invested a total of 

$4.4 billion in 117 independent banks and bank and thrift holding companies during 

the second quarter, and nearly all of these were community banks. This compares 

to a total of more than $200 billion invested since the program began. Average regulatory capital ratios increased in the quarter as well. The leverage capital ratio increased to 8.25 percent, while the average total risk-based capital ratio rose to 13.76 

percent. However, while the average ratios increased, fewer than half of all institutions reported increases in their regulatory capital ratios. The nation’s nearly 7,500 community banks—those with less than $1 billion in 

total assets—hold approximately 11 percent of total industry assets. They posted an 

average return on assets of negative 0.06 percent, which was slightly better than 

the industry as a whole. As larger banks often have more diverse sources of noninterest income, community banks typically get a much greater share of their operating income from net interest income. In general, community banks have higher 

capital ratios than their larger competitors and are much more reliant on deposits 

as a source of funding. 

Average ratios of noncurrent loans and charge-offs are lower for community banks 

than the industry averages. In part, this illustrates the differing loan mix between 

the two groups. The larger banks’ loan performance reflects record high loss rates 

on credit card loans and record delinquencies on mortgage loans. Community banks 

are important sources of credit for the nation’s small businesses and small farmers. 

As of June 30, community banks held 38 percent of the industry’s small business 

and small farm loans.4 However, the greatest exposures faced by community banks 

may relate to construction loans and other CRE loans. These loans made up over 

43 percent of community bank portfolios, and the average ratio of CRE loans to total 

capital was above 280 percent. 

As insured institutions work through their troubled assets, the list of ‘‘problem 

institutions’’—those rated CAMELS 4 or 5—will grow. Over a hundred institutions 

were added to the FDIC’s ‘‘problem list’’ in the second quarter. The combined assets 

of the 416 banks and thrifts on the problem list now total almost $300 billion. However, the number of problem institutions is still well below the more than 1,400 

identified in 1991, during the last banking crisis on both a nominal and a percentage basis. Institutions on the problem list are monitored closely, and most do not 

fail. Still, the rising number of problem institutions and the high number of failures 

reflect the challenges that FDIC-insured institutions continue to face. 

Risks to FDIC–Insured Institutions 

Troubled loans at FDIC-insured institutions have been concentrated thus far in 

three main areas—residential mortgage loans, construction loans, and credit cards. 

The credit quality problems in 1-to-4 family mortgage loans and the coincident declines in U.S. home prices are well known to this Committee. Net chargeoffs of 1- 

to 4-famly mortgages and home equity lines of credit by FDIC-insured institutions 

over the past 2 years have totaled more than $65 billion. Declining home prices 

have also impacted construction loan portfolios, on which many small and mid-sized 

banks heavily depend. There has been a tenfold increase in the ratio of noncurrent 

construction loans since mid-year 2007, and this ratio now stands at a near-record 

13.5 percent. Net charge-offs for construction loans over the past 2 years have totaled about $32 billion, and almost 40 percent of these were for one-to-four family 

construction. 

With the longest and deepest recession since the 1930s has come a new round of 

credit problems in consumer and commercial loans. The net charge-off rate for credit 

card loans on bank portfolios rose to record-high 9.95 percent in the second quarter. 

While stronger underwriting standards and deleveraging by households should 

eventually help bring loss rates down, ongoing labor market distress threatens to 

keep loss rates elevated for an extended period. By contrast, loans to businesses, 

i.e., commercial and industrial (C&I) loans, have performed reasonably well given 

the severity of the recession in part because corporate balance sheets were comparatively strong coming into the recession. The noncurrent loan ratio of 2.79 percent 

for C&I loans stands more than four times higher than the record low seen in 2007, 

but remains still well below the record high of 5.14 percent in 1987. 

The most prominent area of risk for rising credit losses at FDIC-insured institutions during the next several quarters is in CRE lending. While financing vehicles 

such as commercial mortgage-backed securities (CMBS) have emerged as significant 
43 

5FDIC, Supervisory Insights, http://www.fdic.gov/regulations/examinations/supervisory/insights/sisum08/article01lPrimer.html. 

CRE funding sources in recent years, FDIC-insured institutions still hold the largest 

share of commercial mortgage debt outstanding, and their exposure to CRE loans 

stands at an historic high. As of June, CRE loans backed by nonfarm, nonresidential 

properties totaled almost $1.1 trillion, or 14.2 percent of total loans and leases. 

The deep recession, in combination with ongoing credit market disruptions for 

market-based CRE financing, has made this a particularly challenging environment 

for commercial real estate. The loss of more than 7 million jobs since the onset of 

the recession has reduced demand for office space and other CRE property types, 

leading to deterioration in fundamental factors such as rental rates and vacancy 

rates. Amid weak fundamentals, investors have been re-evaluating their required 

rate of return on commercial properties, leading to a sharp rise in ‘‘cap rates’’ and 

lower market valuations for commercial properties. Finally, the virtual shutdown of 

CMBS issuance in the wake of last year’s financial crisis has made financing harder 

to obtain. Large volumes of CRE loans are scheduled to roll over in coming quarters, 

and falling property prices will make it more difficult for some borrowers to renew 

their financing. 

Outside of construction portfolios, losses on loans backed by CRE properties have 

been modest to this point. Net charge-offs on loans backed by nonfarm, nonresidential properties have been just $6.2 billion over the past 2 years. Over this period, 

however, the noncurrent loan ratio in this category has quadrupled, and we expect 

it to rise further as more CRE loans come due over the next few years. The ultimate 

scale of losses in the CRE loan portfolio will very much depend on the pace of recovery in the U.S. economy and financial markets during that time. 

FDIC Response to Industry Risks and Challenges 

Supervisory Response to Problems in Banking Industry 

The FDIC has maintained a balanced supervisory approach that focuses on vigilant oversight but remains sensitive to the economic and real estate market conditions. Deteriorating credit quality has caused a reduction in earnings and capital 

at a number of institutions we supervise which has resulted in a rise in problem 

banks and the increased issuance of corrective programs. We have been strongly advocating increased capital and loan loss allowance levels to cushion the impact of 

rising non-performing assets. Appropriate allowance levels are a fundamental tenet 

of sound banking, and we expect that banks will add to their loss reserves as credit 

conditions warrant—and in accordance with generally accepted accounting principles. 

We have also been emphasizing the importance of a strong workout infrastructure 

in the current environment. Given the rising level of non-performing assets, and difficulties in refinancing loans coming due because of decreased collateral values and 

lack of a securitization market, banks need to have the right resources in place to 

restructure weakened credit relationships and dispose of other real estate holdings 

in a timely, orderly fashion. 

We have been using a combination of offsite monitoring and onsite examination 

work to keep abreast of emerging issues at FDIC-supervised institutions and are accelerating full-scope examinations when necessary. Bankers understand that FDIC 

examiners will perform a thorough, yet balanced asset review during our examinations, with a particular focus on concentrations of credit risk. Over the past several 

years, we have emphasized the risks in real estate lending through examination and 

industry guidance, training, and targeted analysis and supervisory activities. Our 

efforts have focused on underwriting, loan administration, concentrations, portfolio 

management and stress testing, proper accounting, and the use of interest reserves. 

CRE loans and construction and development loans are a significant examination 

focus right now and have been for some time. Our examiners in the field have been 

sampling banks’ CRE loan exposures during regular exams as well as special visitations and ensuring that credit grading systems, loan policies, and risk management 

processes have kept pace with market conditions. We have been scrutinizing for 

some time construction and development lending relationships that are supported 

by interest reserves to ensure that they are prudently administrated and accurately 

portray the borrower’s repayment capacity. In 2008, we issued guidance and produced a journal article on the use of interest reserves,5 as well as internal review 

procedures for examiners. 

We strive to learn from those instances where the bank’s failure led to a material 

loss to the DIF, and we have made revisions to our examination procedures when 

warranted. This self-assessment process is intended to make our procedures more 
44 

forward-looking, timely and risk-focused. In addition, due to increased demands on 

examination staff, we have been working diligently to hire additional examiners 

since 2007. During 2009, we hired 440 mid career employees with financial services 

skills as examiners and almost another 200 examiner trainees. We are also conducting training to reinforce important skills that are relevant in today’s rapidly 

changing environment. The FDIC continues to have a well-trained and capable supervisory workforce that provides vigilant oversight of state nonmember institutions. 

Measures to Ensure Examination Programs Don’t Interfere with Credit Availability 

Large and small businesses are contending with extremely challenging economic 

conditions which have been exacerbated by turmoil in the credit markets over the 

past 18 months. These conditions, coupled with a more risk-averse posture by lenders, have diminished the availability of credit. 

We have heard concerns expressed by Members of Congress and industry representatives that banking regulators are somehow instructing banks to curtail lending, making it more difficult for consumers and businesses to obtain credit or roll 

over otherwise performing loans. This is not the case. The FDIC provides banks 

with considerable flexibility in dealing with customer relationships and managing 

loan portfolios. I can assure you that we do not instruct banks to curtail prudently 

managed lending activities, restrict lines of credit to strong borrowers, or require 

appraisals on performing loans unless an advance of new funds is being contemplated. 

It has also been suggested that regulators are expecting banks to shut off lines 

of credit or not roll-over maturing loans because of depreciating collateral values. 

To be clear, the FDIC focuses on borrowers’ repayment sources, particularly their 

cash-flow, as a means of paying off loans. Collateral is a secondary source of repayment and should not be the primary determinant in extending or refinancing loans. 

Accordingly, we have not encouraged banks to close down credit lines or deny a refinance request solely because of weakened collateral value. 

The FDIC has been vocal in its support of bank lending to small businesses in 

a variety of industry forums and in the interagency statement on making loans to 

creditworthy borrowers that was issued last November. I would like to emphasize 

that the FDIC wants banks to make prudent small business loans as they are an 

engine of growth in our economy and can help to create jobs at this critical juncture. 

In addition, the Federal banking agencies will soon issue guidance on CRE loan 

workouts. The agencies recognize that lenders and borrowers face challenging credit 

conditions due to the economic downturn, and are frequently dealing with diminished cash-flows and depreciating collateral values. Prudent loan workouts are often 

in the best interest of financial institutions and borrowers, particularly during difficult economic circumstances and constrained credit availability. This guidance reflects that reality, and supports prudent and pragmatic credit and business decisionmaking within the framework of financial accuracy, transparency, and timely loss 

recognition. 

Innovative resolution structures 

The FDIC has made several changes to its resolution strategies in response to this 

crisis, and we will continue to re-evaluate our methods going forward. The most important change is an increased emphasis on partnership arrangements. The FDIC 

and RTC used partnership arrangements in the past—specifically loss sharing and 

structured transactions. In the early 1990s, the FDIC introduced and used loss sharing. During the same time period, the RTC introduced and used structured transactions as a significant part of their asset sales strategy. As in the past, the FDIC 

has begun using these types of structures in order to lower resolution costs and simplify the FDIC’s resolution workload. Also, the loss share agreements reduce the 

FDIC’s liquidity needs, further enhancing the FDIC’s ability to meet the statutory 

least cost test requirement. 

The loss share agreements enable banks to acquire an entire failed bank franchise 

without taking on too much risk, while the structured transactions allow the FDIC 

to market and sell assets to both banks and non-banks without undertaking the 

tasks and responsibilities of managing those assets. Both types of agreements are 

partnerships where the private sector partner manages the assets and the FDIC 

monitors the partner. An important characteristic of these agreements is the alignment of interests: both parties benefit financially when the value of the assets is 

maximized. 

For the most part, after the end of the savings and loan and banking crisis of the 

late 1980s and early 1990s, the FDIC shifted away from these types of agreements 

to more traditional methods since the affected asset markets became stronger and 
45 

6The FDIC reported a negative fund balance as of December 31, 1991 of approximately –$7.0 billion due to setting aside a large ($16.3 billion) reserve for future failures. The fund remained 

negative for five quarters, until March 31, 1993, when the fund balance was approximately $1.2 

billion. 

more liquid. The main reason why we now are returning to these methods is that 

in the past several months investor interest has been low and asset values have 

been uncertain. If we tried to sell the assets of failed banks into today’s markets, 

the prices would likely be well below their intrinsic value—that is, their value if 

they were held and actively managed until markets recover. The partnerships allow 

the FDIC to sell the assets today but still benefit from future market improvements. 

During 2009, the FDIC has used loss share for 58 out of 98 resolutions. We estimate 

that the cost savings have been substantial: the estimated loss rate for loss share 

failures averaged 25 percent; for all other transactions, it was 38 percent. Through 

September 30, 2009, the FDIC has entered into seven structured transactions, with 

about $8 billion in assets. 

To address the unique nature of today’s crisis, we have made several changes to 

the earlier agreements. The earlier loss share agreements covered only commercial 

assets. We have updated the agreements to include single family assets and to require the application of a systematic loan modification program for troubled mortgage loans. We strongly encourage our loss share partners to adopt the Administration’s Home Affordable Modification Program (HAMP) for managing single family 

assets. If they do not adopt the HAMP, we require them to use the FDIC loan modification program which was the model for the HAMP modification protocol. Both are 

designed to ensure that acquirers offer sustainable and affordable loan modifications 

to troubled homeowners whenever it is cost-effective. This serves to lower costs and 

minimize foreclosures. We have also encouraged our loss share partners to deploy 

forbearance programs when homeowners struggle with mortgage payments due to 

life events (unemployment, illness, divorce, etc.). We also invite our loss share partners to propose other innovative strategies that will help keep homeowners in their 

homes and reduce the FDIC’s costs. 

In addition, the FDIC has explored funding changes to our structured transactions to make them more appealing in today’s environment. To attract more bidders and hopefully higher pricing, the FDIC has offered various forms of leverage. 

In recent transactions where the leverage was provided to the investors, the highest 

bids with the leverage option substantially improved the overall economics of the 

transactions. The overall feedback on the structure from both investors and market 

participants was very positive. 

The Condition of the Deposit Insurance Fund 

Current Conditions and Projections 

As of June 30, 2009, the balance (or net worth) of the DIF (the fund) was approxi- mately $10 billion. The fund reserve ratio—the fund balance divided by estimated 

insured deposits in the banking system—was 0.22 percent. In contrast, on December 

31, 2007, the fund balance was almost $52 billion and the reserve ratio was 1.22 

percent. Losses from institution failures have caused much of the decline in the fund 

balance, but increases in the contingent loss reserve—the amount set aside for 

losses expected during the next 12 months—has contributed significantly to the decline. The contingent loss reserve on June 30 was approximately $32 billion. 

The FDIC estimates that as of September 30, 2009, both the fund balance and 

the reserve ratio were negative after reserving for projected losses over the next 12 

months, though our cash position remained positive. This is not the first time that 

a fund balance has been negative. The FDIC reported a negative fund balance during the last banking crisis in the late 1980s and early 1990s.6 Because the FDIC 

has many potential sources of cash, a negative fund balance does not affect the 

FDIC’s ability to protect insured depositors or promptly resolve failed institutions. 

The negative fund balance reflects, in part, an increase in provisioning for anticipated failures. The FDIC projects that, over the period 2009 through 2013, the fund 

could incur approximately $100 billion in failure costs. The FDIC projects that most 

of these costs will occur in 2009 and 2010. In fact, well over half of this amount 

will already be reflected in the September 2009 fund balance. Assessment revenue 

is projected to be about $63 billion over this 5-year period, which exceeds the remaining loss amount. The problem we are facing is one of timing. Losses are occurring in the near term and revenue is spread out into future years. 

At present, cash and marketable securities available to resolve failed institutions 

remain positive, although they have also declined. At the beginning of the current 

banking crisis, in June 2008, total assets held by the fund were approximately $55 

billion, and consisted almost entirely of cash and marketable securities (i.e., liquid 
46 

7Liquid balances include balances due from Federal Reserve Banks, depository institutions 

and others, Federal funds sold, and securities purchased under agreements to resell. 

assets). As the crisis has unfolded, the liquid assets of the fund have been expended 

to protect depositors of failed institutions and have been exchanged for less liquid 

claims against the assets of failed institutions. As of June 30, 2009, while total assets of the fund had increased to almost $65 billion, cash and marketable securities 

had fallen to about $22 billion. The pace of resolutions continues to put downward 

pressure on cash balances. While the less liquid assets in the fund have value that 

will eventually be converted to cash when sold, the FDIC’s immediate need is for 

more liquid assets to fund near-term failures. 

If the FDIC took no action under its existing authority to increase its liquidity, 

the FDIC projects that its liquidity needs would exceed its liquid assets next year. 

The FDIC’s Response 

The FDIC has taken several steps to ensure that the fund reserve ratio returns 

to its statutorily mandated minimum level of 1.15 percent within the time prescribed by Congress and that it has sufficient cash to promptly resolve failing institutions. 

For the first quarter of 2009, the FDIC raised rates by 7 basis points. The FDIC 

also imposed a special assessment as of June 30, 2009 of 5 basis points of each institution’s assets minus Tier 1 capital, with a cap of 10 basis points of an institution’s 

regular assessment base. On September 22, the FDIC again took action to increase 

assessment rates—the board decided that effective January 1, 2011, rates will uniformly increase by 3 basis points. The FDIC projects that bank and thrift failures 

will peak in 2009 and 2010 and that industry earnings will have recovered sufficiently by 2011 to absorb a 3 basis point increase in deposit insurance assessments. 

We project that these steps should return the fund to a positive balance in 2012 

and the reserve ratio to 1.15 percent by the first quarter of 2017. 

While the final rule imposing the special assessment in June permitted the FDIC 

to impose additional special assessments of the same size this year without further 

notice and comment rulemaking, the FDIC decided not to impose any additional 

special assessments this year. Any additional special assessment would impose a 

burden on an industry that is struggling to achieve positive earnings overall. In general, an assessment system that charges institutions less when credit is restricted 

and more when it is not is more conducive to economic stability and sustained 

growth than a system that does the opposite. 

To meet the FDIC’s liquidity needs, on September 29 the FDIC authorized publication of a Notice of Proposed Rulemaking (NPR) to require insured depository institutions to prepay about 3 years of their estimated risk-based assessments. The 

FDIC estimates that prepayment would bring in approximately $45 billion in cash. 

Unlike a special assessment, prepaid assessments would not immediately affect 

the DIF balance or depository institutions’ earnings. An institution would record the 

entire amount of its prepaid assessment as a prepaid expense (asset) as of December 

30, 2009. As of December 31, 2009, and each quarter thereafter, the institution 

would record an expense (charge to earnings) for its regular quarterly assessment 

for the quarter and an offsetting credit to the prepaid assessment until the asset 

is exhausted. Once the asset is exhausted, the institution would record an expense 

and an accrued expense payable each quarter for its regular assessment, which 

would be paid in arrears to the FDIC at the end of the following quarter. On the 

FDIC side, prepaid assessments would have no effect on the DIF balance, but would 

provide us with the cash needed for future resolutions. 

The proposed rule would allow the FDIC to exercise its discretion as supervisor 

and insurer to exempt an institution from the prepayment requirement if the FDIC 

determines that the prepayment would adversely affect the safety and soundness of 

the institution. 

The FDIC believes that using prepaid assessments as a means of collecting 

enough cash to meet upcoming liquidity needs to fund future resolutions has significant advantages compared to imposing additional or higher special assessments. Additional or higher special assessments could severely reduce industry earnings and 

capital at a time when the industry is under stress. Prepayment would not materially impair the capital or earnings of insured institutions. In addition, the FDIC believes that most of the prepaid assessment would be drawn from available cash and 

excess reserves, which should not significantly affect depository institutions’ current 

lending activities. As of June 30, FDIC-insured institutions held more than $1.3 trillion in liquid balances, or 22 percent more than they did a year ago.7

In the FDIC’s view, requiring that institutions prepay assessments is also preferable to borrowing from the U.S. Treasury. Prepayment of assessments ensures 
47 

* Statement Required by 12 U.S.C. § 250: The views expressed herein are those of the Office 

of the Comptroller of the Currency and do not necessarily represent the views of the President. 

that the deposit insurance system remains directly industry-funded and it preserves 

Treasury borrowing for emergency situations. Additionally, the FDIC believes that, 

unlike borrowing from the Treasury or the FFB, requiring prepaid assessments 

would not count toward the public debt limit. Finally, collecting prepaid assessments would be the least costly option to the fund for raising liquidity as there 

would be no interest cost. However, the FDIC is seeking comment on these and 

other options in the NPR. 

The FDIC’s proposal requiring prepayment of assessments is really about how and 

when the industry fulfills its obligation to the insurance fund. It is not about whether insured deposits are safe or whether the FDIC will be able to promptly resolve 

failing institutions. Deposits remain safe; the FDIC has ample resources available 

to promptly resolve failing institutions. We thank the Congress for raising our borrowing limit, which was important from a public confidence standpoint and essential 

to assure that the FDIC is prepared for all contingencies in these difficult times. 

Conclusion 

FDIC-insured banks and thrifts continue to face many challenges. However, there 

is no question that the FDIC will continue to ensure the safety and soundness of 

FDIC-insured financial institutions, and, when necessary, resolve failed financial institutions. Regarding the state of the DIF and the FDIC Board’s recent proposal to 

have banks pay a prepaid assessment, the most important thing for everyone to remember is that the outcome of this proposal is a non-event for insured depositors. 

Their deposits are safe no matter what the Board decides to do in this matter. Everyone knows that the FDIC has immediate access to a $100 billion credit line at 

Treasury that can be expanded to $500 billion with the concurrence of the Federal 

Reserve and the Treasury. We also have authority to borrow additional working capital up to 90 percent of the value of assets we own. The FDIC’s commitment to depositors is absolute, and we have more than enough resources at our disposal to 

make good on that commitment. 

I would be pleased to answer any questions from the members of the Subcommittee. 

PREPARED STATEMENT OF JOHN C. DUGAN * 

COMPTROLLER OF THE CURRENCY

OFFICE OF THE COMPTROLLER OF THE CURRENCY

OCTOBER 14, 2009 

I. Introduction 

Chairman Johnson, Senator Crapo, and members of the Subcommittee, I am 

pleased to testify on the current condition of the national banking system, including 

trends in bank ending, asset quality, and problem banks. The OCC supervises over 

1,600 national banks and Federal branches, which constitute approximately 18 percent of all federally insured banks and thrifts, holding just over 61 percent of all 

bank and thrift assets. These nationally chartered institutions include 15 of the very 

largest U.S. banks, with assets generally exceeding $100 billion; 23 mid-sized banks, 

with assets generally ranging between $10 billion and $100 billion; and over 1,500 

community banks and trust banks, with assets between $1.5 million and $10 billion. 

The OCC has dedicated supervisory programs for these three groups of institutions 

that are tailored to the unique challenges faced by each. 

My testimony today makes three key points. First, credit quality is continuing to 

deteriorate across almost all classes of banking assets in nearly all sizes of banks. 

As the economy has weakened, the strains on borrowers that first appeared in the 

housing sector have spread to other retail and commercial borrowers. For some credit portfolio segments, the rate of nonperforming loans is at or near historical highs. 

In many cases, this declining asset quality reflects risks that built up over time, and 

while we may be seeing some initial signs of improvement in some asset classes as 

the economy begins to recover, it will generally take time for problem credits to 

work their way through the banking system. 

Second, the vast majority of national banks are strong and have the financial capacity to withstand the declining asset quality. As I noted in my testimony last year 

before the full Committee, we anticipated that credit quality would worsen and that 
48 

1Testimony of John C. Dugan before the Committee on Banking, Housing, and Urban Affairs, 

United States Senate, June 5, 2008, page 2. 2The TED spread reflects the difference between the interest rates on interbank loans in the 

Eurodollar market and short-term U.S. Government Treasury bills. The OIS is the overnight 

indexed swap rate. Both spreads are a measure of how markets are viewing the risks of financial counterparties. 

banks would need to further strengthen their capital and loan loss reserves.1 Net 

capital levels in national banks have increased by over $186 billion over the last 

2 years, and net increases to loan loss reserves have exceeded $92 billion. While 

these increases have considerably strengthened national banks, we anticipate additional capital and reserves will be needed to absorb the additional potential losses 

in banks’ portfolios. In some cases that may not be feasible, however, and as a result, there will continue to be a number of smaller institutions that are not likely 

to survive their mounting credit problems. In these cases we are working closely 

with the FDIC to ensure timely resolutions in a manner that is least disruptive to 

local communities. 

Third, during this stressful period we are extremely mindful of the need to take 

a balanced approach in our supervision of national banks, and we strive continually 

to ensure that our examiners are doing just that. We are encouraging banks to work 

constructively with borrowers who may be facing difficulties and to make new loans 

to creditworthy borrowers. And we have repeatedly and strongly emphasized that 

examiners should not dictate loan terms or require banks to charge off loans simply 

due to declines in collateral values. 

Balanced supervision, however, does not mean turning a blind eye to credit and 

market conditions, or simply allowing banks to forestall recognizing problems on the 

hope that markets or borrowers may turn around. As we have learned in our dealings with problem banks, a key factor in restoring a bank to health is ensuring that 

bank management realistically recognizes and addresses problems as they emerge, 

even as they work with struggling borrowers. 

II. Condition of the National Banking System: Credit Quality Has Replaced 

Liquidity as Major Concern 

Beginning in the fall of 2007 and extending through the first quarter of this year, 

bank regulators and the industry were confronted with unprecedented disruptions 

in the global financial markets. In the wake of severe problems with subprime mortgages, the value of various securitized assets and structured investment products 

declined precipitously. Key funding and short term credit markets froze, sparking 

a severe contraction in the liquidity that sustains much of our economy and banking 

system, including uninsured deposit funding. The combination of these events led 

to failures, government assistance, and government takeover of several major financial institutions. Through the collective efforts and programs resulting from actions 

taken by Congress, the Treasury Department, the Federal Reserve Board, the Federal Deposit Insurance Corporation, and governments around the world, there has 

been significant stabilization in credit and funding markets for all financial institutions, including banks of all sizes. 

As reflected in both the TED and Libor-OIS spreads,2 each of which has fallen 

to less than 20 basis points after peaking at well over 300 basis points during the 

crisis, the interbank funding market has vastly improved, with banks once again 

willing to extend credit to counterparties. There has also been a slight rebound in 

certain securitization markets. For example, non-mortgage asset-backed securities 

issuance for 2Q:2009 totaled $49 billion, up 121 percent from 1Q:2009. Similarly, 

syndicated market loan issuances increased to $156 billion in 2Q:2009, up 37 percent from 1Q:2009. 

The drag on national banks’ balance sheets and earnings from the overhang of 

various structured securities products has been very significantly reduced due to the 

substantial write-downs that banks took on these assets in 4Q:2008 and 1Q:2009 

and the overall recovery in credit markets. Losses sustained at our 10 largest banking companies for these securities reached $44 billion in 2008, but dropped to $8 

billion in 1Q:2009 and $1 billion in 2Q:2009. There are some banks that still face 

strains in their investment portfolios, largely due to their holding of certain private 

label mortgage-backed and trust preferred securities. While most banks will be able 

to absorb the losses that may arise from these holdings, there is a small population 

of banks that have significant concentrations in these products that we are closely 

monitoring. We expect these banks will continue to take incremental credit impairments through earnings until mortgage metrics improve. 

In my financial condition testimony before the full Committee last year, I observed that, as market conditions began to stabilize, the focus of supervisors and 
49 

3Testimony of John C. Dugan before the Committee on Banking, Housing, and Urban Affairs, 

United States Senate, June 5, 2008, page 9. 

bankers would increasingly turn to the more traditional challenges of identifying 

and managing problem credits.3 That has indeed proven to be the case, as declining 

asset quality has become the central challenge facing banks and supervisors today. 

While there recently have been some signs of economic recovery, data through the 

second quarter of this year demonstrate that asset quality across the national bank 

population significantly deteriorated over the preceding twelve months, as both retail and commercial borrowers remained under stress from job losses and the overall 

contraction in the economy. The percentage of noncurrent loans (loans that are 90 

days or more past due or on nonaccrual) increased dramatically and reached the 

highest level in at least twenty 5 years (see Chart 1). 

In addition, the rate at which banks are charging off loans has also accelerated 

and, for some portfolio segments, now exceeds previous peaks experienced during 

the last credit cycle. Continued concerns about the economy are also affecting loan 

growth and demand as businesses, consumers, and bankers themselves retrench on 

the amount of leverage and borrowing they want to assume. As a result, loan 

growth through 2Q:2009 has slowed across the national bank population and in various portfolio segments. (See charts 2 and 3) 
50 

A number of factors are evident for this decline in credit, including the following: 

• Reduction in loan demand, as reductions in consumer spending have caused 

businesses to cut back on inventory and other investments; 
51 

• Reduction in the demand for credit from borrowers who may have been able to 

afford or repay a loan when the economy was expanding, but now face constrained income or cash-flow and debt service capacity; 

• Reductions in loan demand as households work to rebuild their net worth, as 

reflected in the increased U.S. savings rate; 

• Actions taken by bankers to scale back their risk exposures due to weaknesses 

in various market and economic sectors, and to strengthen underwriting standards and loan terms that had become, in retrospect, too relaxed. In addition, 

many banks have increasingly shifted their focus and resources to loan collections, workouts, and resolutions, and some troubled banks have curtailed lending due to funding and capital constraints; and 

• Continued uncertainty on the part of borrowers and lenders about the strength 

and speed of the economic recovery in many regions of the country. 

As demonstrated in chart 4 below, businesses have significantly reduced their investments and inventories and, in an effort to strengthen their own balance sheets, 

many larger businesses have replaced short-term borrowing with longer-term corporate bond issues. Similarly, chart 5 shows that consumers are repairing their personal balance sheets with significant increases in their personal savings rates. 
52 

4OCC Survey of Underwriting Practices 2009, page 3. 

5 Board of Governors of the Federal Reserve System, ‘‘The July 2009 Senior Loan Officer Survey on Bank Lending Practices,’’ page 1. 

This interplay of factors and their effects on lending are consistent with our recent annual underwriting survey and the Federal Reserve Board’s most recent Senior Loan Officer Survey. OCC examiners report that the financial market disruption 

continues to affect bankers’ appetite for risk and has resulted in a renewed focus 

on fundamental credit principles by bank lenders. Our survey indicates that primary factors contributing to stronger underwriting standards are bankers’ concerns 

about unfavorable external conditions and product performance.4 In its July Senior 

Loan Officer Survey, the Federal Reserve reported that ‘‘demand for loans continued 

to weaken across all major categories except for prime residential mortgages.’’5

Some have also suggested that unnecessary supervisory actions may have significantly contributed to the decline in credit availability. While I do not believe the 

evidence supports this suggestion, I do believe, as addressed in more detail at the 

end of this testimony, that it is critical for supervisors to stay focused on the type 

of balanced supervision that is required in the stressful credit conditions prevalent 

today. 

Finally, the combination of deteriorating credit quality, lower yields on earning 

assets, and slower loan growth is the primary factor currently affecting national 

banks’ earnings. As shown in Chart 6, there has been a marked deterioration in the 

return on equity across the national banking population as modest increases in 

banks’ net interest margins due to more favorable costs of funds have failed to offset 

credit quality problems and the continued need for banks to build loan loss reserves. 
53 

III. Trends in Key Credit Portfolios and Capital and Reserve Positions 

Against this backdrop, let me now describe trends in major credit segments and 

in capital and loan loss reserve levels. 

A. Retail Credit 

Although retail loans—mortgages, home equity, credit cards, and other consumer 

loans—account for just over half of total loans in the national banking system, they 

currently account for two-thirds of total losses, delinquencies, and nonperforming 

credits. To a large extent, however, these problems are confined to the largest 15 

national banks, which hold almost 91 percent of retail loans in the national banking 

system. 

1. First and Second Mortgages 

The residential mortgage sector was the epicenter of the financial turmoil and 

continues to figure prominently in the current condition of the banking industry. As 

the economy has worsened, problems that started in the subprime market have 

spread to the so-called ‘‘Alt A’’ market, and increasingly, to the prime market. While 

over-leverage and falling housing prices were the initial drivers of delinquencies and 

loan losses, borrower strains resulting from rising unemployment and underemployment are an increasingly important factor. In the first mortgage market, the June 

30, 2009 Mortgage Bankers Association’s National Delinquency Survey shows continued growth in foreclosure inventory, but a relatively flat rate of new foreclosure 

starts overall between the first and second quarter of this year. The rate of prime 

foreclosures, however, continues to increase, with starts at about 1 percent of the 

surveyed population as of the end of the second quarter. Although this percentage 

is still relatively small, the impact is significant given the much larger size of the 

prime market segment compared to the markets for subprime and Alt-A loans. 

While it is true that many first mortgages were sold to third party investors via 

the securitization market, and the loan quality of such mortgages retained by banks 

is generally higher than those sold to third parties, it nevertheless remains the case 

that a number of larger banks have significant on-balance sheet exposure to first 

mortgage losses from portfolios that continue to deteriorate. 

The same is true of second mortgages—home equity loans and lines of credit— 

except that the overwhelming majority of these loans reside on bank balance sheets. 

There were some positive signs in the second quarter showing home equity loan de-
54 

6See OCC News Release 2009–118, September 30, 2009. 

linquency rates falling, and the pace of increase in second lien charge-off rates slowing. But the hard fact is that losses on these loans through the first half of this 

year nearly equaled total losses for all of 2008, and loss rates are expected to continue to climb—though at a slower rate—through at least the middle of 2010. 

In short, deterioration in the first and second residential mortgage markets continue to dominate the credit quality performance in national banks’ retail portfolios, 

as it has since the second half of 2008. Total delinquent and nonperforming residential real estate loans (mortgage and home equity) in national banks now hover 

around 9.4 percent, with a loss rate of just over 2.5 percent—the highest level since 

we have been collecting this data. 

There have been some positive indicators in the housing market in recent months 

that could slow the pace of losses in residential mortgages, including increased home 

sales in June and July, and slight increases in the Case-Shiller composite index for 

certain metropolitan areas. While these signs are encouraging, it is too early to determine whether they signal a true turning point in this sector. For example, the 

increase in home sales this summer is consistent with seasonal trends and may not 

be sustainable. In addition, sales may be enjoying a temporary boost from the FirstTime Homebuyer Tax Credit program which, unless extended, will end in November. Much will depend, of course, on the extent to which economic recovery takes 

hold and truly stabilizes the housing market. 

In terms of mortgage modifications, all of the major national bank mortgage 

servicers are actively participating in the Administration’s Making Home Affordable 

Program. Servicers have been significantly expanding their staff levels in the loss 

mitigation/collection areas—doubling and tripling customer contact personnel, and 

requiring night and weekend overtime work. Servicers have also been ramping up 

their training efforts, customer service scripts, and automated qualification and underwriting systems to improve the processing of loan modification requests. The 

OCC is closely monitoring these and other home modification efforts through onsite 

examinations and other ongoing supervisory initiatives, as well as through our 

Mortgage Metrics quarterly reporting program. And examiners continue to monitor 

modification programs for compliance with all applicable fair lending and consumer 

compliance laws. 

Our latest Mortgage Metrics report shows that actions to keep Americans in their 

homes grew by almost 22 percent during 2Q:2009.6 Notably, the percentage of modifications that reduced borrowers’ monthly principal and interest payments continued 

to increase to more than 78 percent of all new modifications, up from about 54 percent in the previous quarter. We view this as a positive development, as modifications that reduce borrowers’ monthly payments generally produce lower levels of redefaults and longer term sustainability than modifications that either increase payments or leave them unchanged. 

2. Credit Cards 

Credit card performance began to deteriorate sharply in the latter part of 2008 

and has continued to weaken further this year, with record levels of losses and delinquencies. As with second lien mortgages, there have been some encouraging signs 

recently in the form of declining early stage delinquency rates, but loss rates continue to climb. As of June 30, the overall loss rate was 10.3 percent for national 

banks, and more recent data shows continued deterioration-with industry analysts 

predicting even higher loss rates into 2010. 

In response to these trends and the overall deterioration in the economy, many 

credit card issuers are adjusting their account management policies to reflect and 

respond to the increased risk in these accounts. In some cases these actions have 

resulted in credit lines being reduced or curtailed. In other cases, they have led to 

increased interest rates, effectively increasing the minimum payment to cover the 

higher finance charges. In still other cases they have resulted in an increase in minimum payments to extinguish the outstanding debt more quickly. Many credit card 

issuers are also re-evaluating certain credit card product features, such as ‘‘no annual fees’’ or various reward programs, and are offering cards with simpler terms 

and conditions, in part due to the recently enacted Credit CARD Act. 

We are monitoring these changes in credit card account terms to ensure that they 

comply with all applicable limit and notice requirements, including those mandated 

by the Credit CARD Act. For example, in July we notified national banks that, effective August 22, 2010, they must conduct periodic reviews of accounts whose interest 

rates have been increased since January 1, 2009, based on factors including market 

conditions and borrower credit risk. More recently, we issued a bulletin advising national banks abut the interim final rules issued by the Federal Reserve under the 
55 

Credit CARD Act that became effective on August 20, 2009. The Federal Reserve’s 

rules require lenders to notify customers 45 days in advance of any rate increase 

or significant changes in credit card account terms and to disclose that consumers 

can have the right to reject these changes. Under the rules, the new rates or terms 

can be applied to any transaction that occurs more than 14 days after the notice 

is provided—even if the customer ultimately rejects those terms. To address the risk 

of consumer confusion, the OCC directed national banks to include an additional 

disclosure not required by the rules to alert consumers, if applicable, to the imposition of the new terms on transactions that occur more than 14 days after thenotice 

is provided, regardless of whether the consumer rejects the change and cancels the 

account. 

As with residential mortgages, we are encouraging national banks to work with 

consumers who may be facing temporary difficulties and hardships, and more banks 

are reaching out to assist customers before they become delinquent. Banks have a 

number of viable default management options to assist in this endeavor, although 

it is important that, as they do so, they continue to appropriately account for losses 

as they occur. 

Card issuers are also reevaluating the size of unused credit lines in response to 

current credit conditions, recent regulatory changes, and recent adoption by the Financial Accounting Standards Board (FASB) of two new accounting standards, 

Statement No. 166, Accounting for Transfers of Financial Assets—an amendment of 

FASB Statement No. 140 (FAS 166) and Statement No. 167, Amendments to FASB 

Interpretation No. 46(R) (FAS 167). These standards become effective for an entity’s 

first fiscal year beginning after November 15, 2009, and will have a significant impact on many banking institutions. In particular, many securitization transactions, 

including credit card securitizations, will likely lose sales accounting treatment, 

prompting the return of the securitized assets to banks’ balance sheets. Although 

we are still evaluating the impact of these changes, we anticipate that they will 

have a material effect on how banks structure transactions, manage risk, and determine the levels of loan loss reserves and regulatory capital they hold for certain assets, including credit cards. The net effect of these changes is that banks will most 

likely face increased funding and capital costs for these products. 

The combination of all these factors has resulted in a decline in overall credit card 

debt outstanding and—especially—overall unfunded credit card commitments, reflecting pullbacks by both consumers and lenders. For national banks, managed 

card outstandings (i.e., funded loans both on and off banks’ balance sheets) declined 

by 4 percent thus far this year, or roughly $27 billion. Unfunded credit card commitments (lines available to customers) have declined more precipitously, by 14.8 percent or $448 billion. These trends are consistent with overall industry data. 

In summary, retail credit quality issues continue to be an area of concern, especially for the larger national banks. Although there are some early signs of delinquency rates declining, with some bankers telling us they are beginning to see adverse trends leveling off, sustained improvements in this sector will largely depend 

on the length and depth of the recession and levels of unemployment. 

B. Commercial and Industrial Loans 

The fallout from the housing and consumer sectors to other segments of the economy is evident in the performance of national banks’ commercial and industrial 

(C&I) loan portfolios. Adverse trends in key performance measures, including 30-day 

or morepast due delinquencies, non-performing rates, and net loss rates, sharply accelerated in the latter part of last year and have continued to trend upward in 2009. 

For example, the percentage of C&I loans that are delinquent or nonperforming has 

risen from a recent historical low of 1.02 percent in 2Q:2007 to 3.90 percent in 

2Q:2009. Although this is the highest rate since the ratio peaked at 4.15 percent 

in 2Q:2002 during the last recession, it is still well below the 1991 recession peak 

of 6.5 percent. 

In contrast to retail loans, which primarily affect the larger national banks, the 

effect of adverse trends in C&I loans is fairly uniform across the national bank population. This segment of loans represents approximately 20 percent of total loans 

in the national banking system, with levels somewhat more concentrated at larger 

institutions than at community banks, where C&I loans account for approximately 

16 percent of total loans. While credit quality indicators are marginally worse at the 

larger national banks, the trend rate and direction are fairly consistent across all 

sizes of national banks. 

One measure of C&I loan quality comes from the Federal banking agencies’ 

Shared National Credit (SNC) program, which provides an annual review of large 

credit commitments that cut across the financial system. These large loans to large 

borrowers are originated by large banks, then syndicated to other banks and many 
56 

7 In fact, nonbanks hold a disproportionate share of classified assets compared with their total 

share of the SNC portfolio, owning 47 percent of classified assets and 52 percent of nonaccrual 

loans, whereas FDICinsured institutions hold only 24.2 percent of classified assets and 22.7 percent of nonaccrual loans. 8See OCC News Release 2009–11, September 24, 2009. 

types of nonbank financial institutions such as securitization pools, hedge funds, insurance companies, and pension funds.7 This year’s review, which was just recently 

completed, also found sharp declines in credit quality. The review, which covered 

8,955 credits totaling $2.9 trillion extended to approximately 5,900 borrowers, found 

a record level of $642 billion in criticized assets—meaning loans or commitments 

that had credit weaknesses—representing approximately 22 percent of the total 

SNC portfolio. Total loss of $53 billion identified in the 2009 review exceeded the 

combined loss of the previous eight SNC reviews and nearly tripled the previous 

high in 2002. Examiners attributed the declining credit quality to weak economic 

conditions and the weak underwriting standards leading up to 2008.8

C. Commercial Real Estate Loans 

The greatest challenge facing many banks and their supervisors is the continued 

deterioration in commercial real estate loans (CRE). There are really two stories 

here, with one related to the other. 

The first involves residential construction and development (C&D) lending, especially with respect to single family homes. Not surprisingly, given the terrible 

strains in the housing sector over the last 2 years, delinquency rates have already 

climbed tohigh levels, with significant losses already realized and more losses continuing to work their way through the banking system. For national banks as of 

June 30, total delinquent and nonperforming rates were at just over 34 percent in 

the largest national banks; 23.4 percent in mid-size banks; and 17.5 percent in community banks. The relative size of these loss rates is somewhat misleading, however, because many community banks and some mid-size banks have much greater 

concentrations in residential C&D loans than the largest banks. As a result, the 

concentrated losses in these smaller institutions has had a much more pronounced 

effect on viability, with concentrated residential C&D lending constituting by far the 

single largest factor in commercial bank failures in the last two years. At this point 

in the credit cycle, we believe the bulk of residential C&D problems have been identified and are being addressed, although a number will continue to produce losses 

that result in more bank failures. 

The second story involves all other types of commercial real estate loans, including loans secured by income producing properties. Credit deterioration has spread 

to these assets as well, and trend lines are definitely worsening, but thus far the 

banking system has not experienced anywhere near the level of delinquency and 

loss as it has in C&D lending. 

Still, the signs are troubling. Declining real estate values caused by rising vacancy rates, increasing investor return requirements, falling rental rates, and weak 

sales are affecting all CRE segments. For example, Property and Portfolio Research 

reports that apartment vacancy rates have hit a 25-plus year high at 8.4 percent 

nationally, and there are similar patterns for retail, office, and warehouse space as 

demand falls across all segments. But unlike the CRE markets in 1991, much of 

the current fallout is driven more by a decrease in demand than from an oversupply 

of properties. 

The outlook for these markets over the near term, especially for the income producing property sector, is not favorable. In general, deterioration in performance for 

these CRE loans lags the economy as borrowers’ cash-flows may be sufficient during 

the early stages of a downturn, but become increasingly strained over time. There 

are alsogrowing concerns about the refinancing risk within the commercial mortgage-backed securities market (CMBS) where there is a currently moderate-butgrowing pipeline of loans scheduled to mature. Permanent or rollover refinancing of 

these loans may be difficult due to the declines in commercial property values coupled with the return to more prudent underwriting standards by both lenders and 

investors. While this is an area that we are monitoring, the largest proportion and 

more problematic of these mortgages will not mature until 2011 and 2012. 

As with C&I loans, trends in total delinquent and nonperforming CRE rates (including C&D loans) have been fairly consistent across all segments of the national 

bank population, climbing to roughly 8.3 percent in 2Q:2009. While C&D losses will 

continue to be most problematic for the banks that have the largest concentrations 

in these assets, theextent to which other types of CRE loan losses will continue to 

climb will depend very much on the overall performance of the economy. 
57 

D. Capital and Reserve Levels 

Perhaps the most critical tools for dealing with and absorbing credit losses are 

substantial levels of capital and reserves. As a result, in anticipation of rising credit 

losses over the last 2 years, the OCC has directed banks to build loan loss reserves 

and strengthen capital. In aggregate, the net amount of capital in national banks 

(i.e., the net increase after items such as losses and dividends and including capital 

as a result of acquisitions and net TARP inflows) has risen by over $186 billion over 

the last 2 years, and the net build to loan loss reserves (i.e., loan loss provisions 

less net credit losses) has been over $92 billion. These increases in loss-absorbing 

resources are critical contributors to the overall health of the national banking system. 

As illustrated by the dotted line in the chart below, the level of reserves to total 

loans in the national banking system has increased dramatically to a ratio of 3.3 

percent, the highest in over 25 years. While such high reserves are imperative for 

dealing with the high level of noncurrent loans, the solid line in the chart below 

shows that more provisions may be needed, because the ratio of reserves to noncurrent loans has continued to decline, to under 100 percent—reflecting the fact that 

the substantial growth in reserves is not keeping pace with the even greater growth 

in noncurrents. 

Substantially building reserves at the same time as credit conditions weaken is 

often described as unduly ‘‘pro-cyclical,’’ because bank earnings decline sharply from 

provisioning well before charge-offs actually occur. That is certainly an accurate 

characterization under the current accounting system for loan loss reserving, although there will always be a need to build reserves to some extent as credit losses 

rise. The issue is really about how much; that is, if reserve levels are high going 

into a credit downturn, then the need to build reserves is far lower than it is when 

the going-in levels are low. Unfortunately, our current accounting standards tend 

to produce very low levels of reserves just before the credit cycle turns downward, 

especially after prolonged periods of benign credit conditions as we had in the first 

part of this decade. In such periods, the backward-looking focus of the current accounting model creates undue pressure to decrease reserve levels even where lenders believe the cycle is turning and credit losses will clearly increase. I strongly believe that a more forward looking accounting model based on expected losses would 

both more accurately account for credit costs and be less pro-cyclical. This is an 

issue that I have been working on as co-chair of the Financial Stability Board’s 
58 

(FSB) Working Group on Provisioning, and I continue to be hopeful that accounting 

standard setters will embrace this type of change as they consider adjustments to 

loan loss provisioning standards. 

IV. Most National Banks Have Capacity to Weather This Storm 

The credit conditions I have just described are stark and will require considerable 

skills by bankers and regulators to work through. Despite these challenges, I believe 

the vast majority of national banks are and will continue to be sound, and that they 

have the wherewithal to manage through this credit cycle. Notwithstanding the negative trends and earnings pressures that banks are facing, we should not lose sight 

that, as of June 30, 2009,97 percent of all national banks satisfied the required minimum capital standards to be considered well capitalized, and 76 percent reported 

positive earnings. 

As previously described, the OCC has separate supervisory programs for Large 

Banks (assets generally exceeding $100 billion); Mid-Sized Banks (assets from $10 

billion to $100 billion); and Community Banks (assets below $10 billion). Let me 

summarize our general assessment of the condition of each group. 

A. Large Banks 

In some respects, large banks faced the earliest challenges, with the disruptions 

in wholesale funding markets, the significant losses they sustained on various structured securities. and the pronounced losses that emerged earlier in their retail credit portfolios. As I mentioned, there are some preliminary indicators that the rate of 

increased problems in the retail sector may have begun to slow, but as with credit 

conditions in general, much of this will depend on the timing and strength of the 

economy, and in particular, on unemployment rates. C&I and CRE loan exposures 

remain a concern for these banks, but they have more diversified portfolios and exposures than many smaller banks and thus may be in a better position to absorb 

these problems. Collectively, the fifteen banks in our Large Bank program raised 

$132 billion in capital (excluding TARP funding) in 2008 and, over the past twenty 

4 months, their net build to loan loss reserves totaled approximately $85 billion. 

Earlier this year we and the other Federal regulators conducted a detailed stress 

test of the largest U.S. banks as part of the Supervisory Capital Assessment Program (SCAP) to examine their ability to withstand even further deterioration in 

market and credit conditions. I believe that was an extremely valuable exercise for 

four reasons. First, the one-time public assessment of individual institution supervisory results—which was only made possible by the U.S. Government backstop 

made available by TARP funding—alleviated a great deal of uncertainty about the 

depth of credit problems on bank balance sheets, which a number of analysts had 

assumed to be in far worse condition. Second, the reduction of uncertainty allowed 

institutions to access private capital markets to increase their capital buffer for possibly severe future losses, instead of requiring more government capital. Third, the 

additional capital required to be raised or otherwise generated now—over $45 billion 

in common stock alone has already been issued by the nine SCAPinstitutions with 

national bank subsidiaries—provides these banks with a strong buffer to absorb the 

severe losses and sharply reduced revenue associated with the adverse stress scenario imposed under SCAP for the 2-year period of 2009 and 2010, should that scenario come to pass. Fourth, as we track banks’ actual credit performance against 

the SCAP adverse stress scenario to ensure that capital levels remain adequate, we 

have found that, through the first half of 2009—which constitutes 25 percent of the 

overall 2-year SCAP stress period—actual aggregate loan losses were well below 25 

percent of the aggregate losses projected for the full SCAP period, and actual aggregate revenues were well above 25 percent of the aggregate projected SCAP revenues. 

While those trends could change as the stress period continues, the early results are 

promising. 

B. Mid-Size Banks 

Although mid-size national banks engage in retail lending, the scope and size of 

their exposures are not as significant as those of the largest national banks. Midsize banks also did not have the significant losses that larger banks did from various structured investment products. Nevertheless, loan growth at these banks 

turned negative in 2Q:2009, and although they experienced modest improvements 

in net interest margins in the second quarter, they still face downward earnings 

pressures, primarily due to increasing loan loss provisions. Given their exposures 

to the C&I and CRE markets, we expect these pressures will persist, notwithstanding the $3.5 billion in net reserve builds over the last twenty four months. 

These banks have also had success in attracting new capital, raising close to $5 billion thus far this year. 
59 

C. Community Banks 

Nearly all national community banks entered this environment with strong capital bases that exceeded regulatory minimums. As a group, they have been less exposed to problems in the retail credit sector that have confronted large and midsize banks, and the vast majority of these banks remain in sound financial condition. As noted earlier, there is a small number of community banks that have concentrations in trust preferred and private label mortgage-backed securities that we 

are closely monitoring. 

Of more significance are the exposures that many community banks have to commercial real estate loans. As I noted in my June 2008 testimony, we have been concerned for some time about the sizable concentrations of CRE loans found at many 

smaller national banks. While national banks of all sizes have significant CRE exposures, as shown in Chart 8, CRE concentrations are most pronounced at community 

and mid-size banks. 

Because of this, the OCC began conducting horizontal reviews of banks with significant concentrations about 5 years ago. As credit conditions worsened, our efforts 

intensified in banks that we believed were at high risk from downturns in real estate markets. Our goal has been to work with bankers to get potential CRE problems identified at an early stage so that bank management can take effective remedial action. In most but not all cases, bank management teams are successfully 

working through their problems and have adequate capital and stable funding bases 

to weather additional loan losses and earnings pressures. 

V. Resolution of Problem Banks 

Given the strains in the economy and banking system, it is not surprising that 

the number of problem banks has increased from the recent historical lows. In the 

early 1990s, the number of problem national banks—those with a CAMELS composite rating of 3, 4 or 5—reached a high of 28 percent of all national banks. Thereafter, the number of problem national banks relative to all national banks dropped 

dramatically and then fluctuated in a range of three to 6 percent until 2007. Since 

then, however, the number of problem banks has risen steadily, and it is now approximately 17 percent of national banks. 

As would be expected, this upward trend in problem banks also has resulted in 

an increased number of bank failures. In January, 2008, we had the first national 

bank failure in almost 4 years, the longest period without a failure in the 146-year 
60 

history of theOCC. That began the current period of significantly increased failures. 

In total, since January 1 of 2008, there have been 123 failures of insured banks and 

thrifts. Of these, 19 have been national banks, accounting for 11 percent of the total 

projected loss to thedeposit insurance fund from all banks that failed during this 

period. All of the 19 failed national banks have been community banks, although 

the total obviously does not include the two large bank holding companies with lead 

national banks that were the subject of systemic risk determinations and received 

extraordinary TARP assistance on an open-institution basis. 

While the vast majority of national banks have the financial capacity and management skills to weather the current environment, some will not. Given the real 

estate concentrations in community banks, the number of problem banks, the severe 

problems in housing markets, and increasing concern with CRE, we expect more 

bank failures in the months ahead. Some troubled banks will be able to find strong 

buyers—in some instances with our assistance—that will enable them to avoid failure and resolution by the FDIC. But that will not always be possible. When it is 

not, our goal, consistent with the provisions of the Federal Deposit Insurance Corporation Improvement Act, is to effect early and least cost resolution of the bank 

with a minimum of disruption to the community. 

VI. OCC Will Continue to Take a Balanced Approach in Our Supervision of 

National Banks 

Finally, I want to underscore the OCC’s commitment to provide a balanced and 

fair approach in our supervision of national banks as bankers work through the 

challenges that are facing them and their borrowers. We recognize the important 

roles that credit availability and prudent lending play in our nation’s economy, and 

we are particularly aware of the vital role that many smaller banks play in meeting 

the credit needs of small businesses in their local communities. Our goal is to ensure that national banks can continue to meet these needs in a safe and sound manner. I have heard some reports that bankers are receiving mixed messages from regulators: on one hand being urged to make loans to creditworthy customers, while at 

the same time being subjected to what some have characterized as ‘‘overzealous’’ 

regulatory examinations. In this context, let me emphasize that our messages to 

bankers have and continue to be straight-forward: 

• Bankers should continue to make loans to creditworthy borrowers; 

• But they should not make loans that they believe are unlikely to be repaid in 

full; and 

• They should continue to work constructively with troubled borrowers—but recognize repayment problems in loans when they see them, because delay and denial only makes things worse. 

Let me also underscore what OCC examiners will and will not do. Examiners will 

not tell bankers to call or renegotiate a loan; dictate loan structures or pricing; or 

prescribe limits (beyond regulatory limits) on types or amounts of loans that a bank 

may make if the bank has adequate capital and systems to support and manage its 

risks. Examiners will look to see that bankers have made loans on prudent terms, 

based on sound analysis of financial and collateral information; that banks have sufficient risk management systems inplace to identify and control risks; that they set 

aside sufficient reserves and capital to buffer and absorb actual and potential losses; 

and that they accurately reflect the condition of their loan portfolios in their financial statements. 

Nevertheless, balanced supervision does not mean that examiners will allow bankers to ignore or mask credit problems. Early recognition and action by management 

are critical factors in successfully rehabilitating a problem bank. Conversely, the 

merepassage of time and hope for improved market conditions are not successful 

resolution strategies. 

We have taken a number of steps to ensure that our examiners are applying these 

principles in a balanced and consistent manner. For example, we hold both regular 

meetings and periodic national teleconferences with our field examiners to convey 

key supervisory messages and objectives. In our April 2008 nationwide call, we reviewed and discussed key supervisory principles for evaluating commercial real estate lending. In April of this year we issued guidance to our examiners on elements 

of an effective workout/restructure program for problem real estate loans. We noted 

that effective workouts can take a number of forms, including simple renewal or extension of the loan terms, extension of additional credit; formal restructuring of the 

loan terms; and, in some cases, foreclosure on underlying collateral. We further reiterated these key principles in a nationwide call with our mid-size and community 

bank examiners earlier this month. 
61 

Through the FFIEC, we are also working with the other Federal and state banking agencies to update and reinforce our existing guidance on working with CRE 

borrowers and to help ensure consistent application of these principles across all 

banks. This guidance will reaffirm that prudent workouts are often in the best interests of both the bank and borrower and that examiners should take a balanced 

approach in evaluating workouts. In particular, examiners should not criticize banks 

that implement effective workouts afterperforming a comprehensive review of the 

borrower’s condition, even if the restructured loans have weaknesses that result in 

adverse credit classification. Nor should they criticize renewed or restructured loans 

to borrowers with a demonstrated ability to repay, merelybecause of a decline in collateral values. Consistent with current policies, loans that are adequately protected 

by the current sound worth and debt service capacity of the borrower, guarantor, 

or the underlying collateral generally will not be classified. However, deferring 

issues for another day does not help the CRE sector or banking industry recover. 

It is important that bankers acknowledge changing risk and repayment sources that 

may no longer be adequate. 

VII. Conclusion 

I firmly believe that the collective measures that government officials, bank regulators, and many bankers have taken in recent months have put our financial system on a much more sound footing. These steps are also crucial to ensuring that 

banks will be ableto continue their role as lenders and financial intermediaries. 

Nonetheless, it is equally clear that there are still many challenges ahead, especially 

with regard to the significant deterioration in credit that both supervisors and bankers must work through. There are no quick fixes to this problem, and there is the 

real potential that, for a large number of banks, credit quality will get worse in the 

months ahead. Notwithstanding the significant loan loss provisions that banks have 

taken over the past 2 years, more may be needed as provisions and resulting loan 

loss reserves have not kept pace with the rapid increase in nonperforming assets. 

The OCC is firmly committed to taking a balanced approach as bankers work 

through these issues. We will continue to encourage bankers to lend and to work 

with borrowers. However, we will also ensure that they do so in a safe and sound 

manner and that they recognize and address their problems on a timely basis. 

PREPARED STATEMENT OF DANIEL K. TARULLO 

MEMBER, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

OCTOBER 14, 2009 

Chairman Johnson, Ranking Member Crapo, and members of the Subcommittee, 

thank you for your invitation to discuss the condition of the U.S. banking industry. 

First, I will review the current conditions in financial markets and the overall economy and then turn to the performance of the banking system, highlighting particular challenges in commercial real estate (CRE) and other loan portfolios. Finally, 

I will address the Federal Reserve’s regulatory and supervisory responses to these 

challenges. 

Conditions in Financial Markets and the Economy 

Conditions and sentiment in financial markets have continued to improve in recent months. Pressures in short-term funding markets have eased considerably, 

broad stock price indexes have increased, risk spreads on corporate bonds have narrowed, and credit default swap spreads for many large bank holding companies, a 

measure of perceived riskiness, have declined. Despite improvements, stresses remain in financial markets. For example, corporate bond spreads remain quite high 

by historical standards, as both expected losses and risk premiums remain elevated. 

Economic growth appears to have moved back into positive territory last quarter, 

in part reflecting a pickup in consumer spending and a slight increase in residential 

investment—two components of aggregate demand that had dropped to very low levels earlier in the year. However, the unemployment rate has continued to rise, 

reaching 9.8 percent in September, and is unlikely to improve materially for some 

time. 

Against this backdrop, borrowing by households and businesses has been weak. 

According to the Federal Reserve’s Flow of Funds accounts, household and nonfinancial business debt contracted in the first half of the year and appears to have 

decreased again in the third quarter. For households, residential mortgage debt and 

consumer credit fell sharply in the first half; the decline in consumer credit continued in July and August. Nonfinancial business debt also decreased modestly in the 

first half of the year and appears to have contracted further in the third quarter 
62 

1For more information about the SCAP, see Ben S. Bernanke (2009), ‘‘The Supervisory Capital Assessment Program,’’ speech delivered at the Federal Reserve Bank of Atlanta 2009 Financial Markets Conference, held in Jekyll Island, Ga., May 11, www.Federalreserve.gov/ 

newsevents/speech/bernanke20090511a.htm. 

as net decreases in commercial paper, commercial mortgages, and bank loans more 

than offset a solid pace of corporate bond issuance. 

At depository institutions, loans outstanding fell in the second quarter of 2009. 

In addition, the Federal Reserve’s weekly bank credit data suggests that bank loans 

to households and to nonfinancial businesses contracted sharply in the third quarter. These declines reflect the fact that weak economic growth can both damp demand for credit and lead to tighter credit supply conditions. 

The results from the Federal Reserve’s Senior Loan Officer Opinion Survey on 

Bank Lending Practices indicate that both the availability and demand for bank 

loans are well below pre-crisis levels. In July, more banks reported tightening their 

lending standards on consumer and business loans than reported easing, although 

the degree of net tightening was well below levels reported last year. Almost all of 

the banks that tightened standards indicated concerns about a weaker or more uncertain economic outlook, and about one-third of banks surveyed cited concerns 

about deterioration in their own current or future capital positions. The survey also 

indicates that demand for consumer and business loans has remained weak. Indeed, 

decreased loan demand from creditworthy borrowers was the most common explanation given by respondents for the contraction of business loans this year. 

Taking a longer view of cycles since World War II, changes in debt flows have 

tended to lag behind changes in economic activity. Thus, it would be unusual to see 

a return to a robust and sustainable expansion of credit until after the overall economy begins to recover. 

Credit losses at banking organizations continued to rise through the second quarter of this year, and banks face risks of sizable additional credit losses given the 

outlook for production and employment. In addition, while the decline in housing 

prices slowed in the second quarter, continued adjustments in the housing market 

suggest that foreclosures and mortgage loan loss severities are likely to remain elevated. Moreover, prices for both existing commercial properties and for land, which 

collateralize commercial and residential development loans, have declined sharply 

in the first half of this year, suggesting that banks are vulnerable to significant further deterioration in their CRE loans. In sum, banking organizations continue to 

face significant challenges, and credit markets are far from fully healed. 

Performance of the Banking System 

Despite these challenges, the stability of the banking system has improved since 

last year. Many financial institutions have been able to raise significant amounts 

of capital and have achieved greater access to funding. Moreover, through the rigorous Supervisory Capital Assessment Program (SCAP) stress test conducted by the 

banking agencies earlier this year, some institutions demonstrated that they have 

the capacity to withstand more-adverse macroeconomic conditions than are expected 

to develop and have repaid the government’s Troubled Asset Relief Program (TARP) 

investments.1 Depositors’ concerns about the safety of their funds during the immediate crisis last year have also largely abated. As a result, financial institutions 

have seen their access to core deposit funding improve. 

However, the banking system remains fragile. Nearly 2 years into a substantial 

recession, loan quality is poor across many asset classes and, as noted earlier, continues to deteriorate as lingering weakness in housing markets affects the performance of residential mortgages and construction loans. Higher loan losses are depleting loan loss reserves at many banking organizations, necessitating large new provisions that are producing net losses or low earnings. In addition, although capital 

ratios are considerably higher than they were at the start of the crisis for many 

banking organizations, poor loan quality, subpar earnings, and uncertainty about future conditions raise questions about capital adequacy for some institutions. Diminished loan demand, more-conservative underwriting standards in the wake of the 

crisis, recessionary economic conditions, and a focus on working out problem loans 

have also limited the degree to which banks have added high quality loans to their 

portfolios, an essential step to expanding profitable assets and thus restoring earnings performance. 

These developments have raised the number of problem banks to the highest level 

since the early 1990s, and the rate of bank and thrift failures has accelerated 

throughout the year. Moreover, the estimated loss rates for the deposit insurance 

fund on bank failures have been very high, generally hovering near 30 percent of 

assets. This high loss level reflects the rapidity with which loan quality has deterio-
63 

2See Board of Governors of the Federal Reserve System, FDIC, Office of the Comptroller of 

the Currency, and Office of Thrift Supervision (2009), ‘‘Credit Quality Declines in Annual 

Shared National Credits Review,’’ joint press release, September 24, www.Federalreserve.gov/ 

newsevents/press/bcreg/20090924a.htm. 

rated during the crisis and suggests that banking organizations may need to continue their high level of loan loss provisioning for some time. Moreover, some of 

these institutions, including those with capital above minimum requirements, may 

need to raise more capital and restrain their dividend payouts for the foreseeable 

future. Indeed, the buildup in capital ratios at large banking organizations has been 

essential to reassuring the market of their improving condition. However, we must 

recognize that capital ratios can be an imperfect indicator of a bank’s overall 

strength, particularly in periods in which credit quality is deteriorating rapidly and 

loan loss rates are moving higher. 

Comparative Performance of Banking Institutions by Asset Size 

Although the broad trends detailed above have affected all financial institutions, 

there are some differences in how the crisis is affecting large financial institutions 

and more locally focused community and regional banks. Consider, for example, the 

50 largest U.S. bank holding companies, which hold more than three-quarters of 

bank holding company assets and now include the major investment banks in the 

United States. While these institutions do engage in traditional lending activities, 

originating loans and holding them on their balance sheets like their community 

bank competitors, they also generate considerable revenue from trading and other 

fee-based activities that are sensitive to conditions in capital markets. These firms 

reported modest profits during each of the first two quarters of 2009. Second-quarter 

net income for these companies at $1.6 billion was weaker than that of the first 

quarter, but was still a great improvement over the $19.8 billion loss reported for 

the second quarter of last year. Net income was depressed by the payment of a significant share of the Federal Deposit Insurance Corporation’s (FDIC) special deposit 

insurance assessment and a continued high level of loan loss provisioning. Contributing significantly to better performance was the improvement of capital markets 

activities and increases in related fees and revenues. 

Community and small regional banks have also benefited from the increased stability in financial markets. However, because they depend largely on revenues from 

traditional lending activities, as a group they have yet to report any notable improvement in earnings or condition since the crisis took hold. These banks—with assets of $10 billion or less representing almost 7,000 banks and 20 percent of commercial bank assets—reported a $2.7 billion loss in the second quarter. Earnings remained weak at these banks due to a historically narrow net interest margin and 

high loan loss provisions. More than one in four of these banks reported a net loss. 

Earnings at these banks were also substantially affected by the FDIC special assessment during the second quarter. 

Loan quality deteriorated significantly for both large and small institutions during the second quarter. At the largest 50 bank holding companies, nonperforming 

assets climbed more than 20 percent, raising the ratio of nonperforming assets to 

4.3 percent of loans and other real estate owned. Most of the deterioration was concentrated in residential mortgage and construction loans, but commercial, CRE, and 

credit card loans also experienced rising delinquency rates. Results of the banking 

agencies’ Shared National Credit review, released in September, also document significant deterioration in large syndicated loans, signaling likely further deterioration 

in commercial loans.2 At community and small regional banks, nonperforming assets increased to 4.4 percent of loans at the end of the second quarter, more than 

six times the level for this ratio at year-end 2006, before the crisis started. Home 

mortgages and CRE loans accounted for most of the increase, but commercial loans 

have also shown marked deterioration during recent quarters. Importantly, aggregate equity capital for the top 50 bank holding companies, and thereby for the banking industry, increased for the third consecutive quarter and reached 8.8 percent of 

consolidated assets as of June 30, 2009. This level was almost 1 percentage point 

above the year-end 2008 level and exceeded the pre-crisis level of midyear 2007 by 

more than 2 percentage points. Risk-based capital ratios for the top 50 bank holding 

companies also remained relatively high: Tier 1 capital ratios were at 10.75 percent, 

and total risk-based capital ratios were at 14.09 percent. Signaling the recent improvement in financial markets since the crisis began, capital increases during the 

first half of this year largely reflected common stock issuance, supported also by reductions in dividend payments. However, asset contraction also accounts for part of 

the improvement in capital ratios. Additionally, of course, the Treasury Capital Pur-
64 

3The CRE loans considered delinquent on banks’ books were non-owner occupied CRE loans 

that were 30 days or more past due. 

chase Program also contributed to the increase in capital in the time since the crisis 

emerged. 

Despite TARP capital investments in some banks and the ability of others to raise 

equity capital, weak earnings led to modest declines in the average capital ratios 

of smaller banks over the past year—from 10.7 percent to 10.4 percent of assets as 

of June 30 of this year. However, risk-based capital ratios remained relatively high 

for most of these banks, with 96 percent maintaining risk-based capital ratios consistent with a ‘‘well capitalized’’ designation under prompt corrective action standards. 

Funding for the top 50 bank holding companies has improved markedly over the 

past year. In addition to benefiting from improvement in interbank markets, these 

companies increased core deposits from 24 percent of total assets at year-end 2008 

to 27 percent as of June 30, 2009. The funding profile for community and small regional banks also improved, as core deposit funding rose to 62 percent of assets and 

reliance on brokered deposits and Federal Home Loan Bank advances edged down 

from historically high levels. 

As already noted, substantial financial challenges remain for both large and small 

banking institutions. In particular, some large regional and community banking 

firms that have built up unprecedented concentrations in CRE loans will be particularly affected by emerging conditions in real estate markets. I will now discuss the 

economic conditions and financial market dislocations affecting CRE markets and 

the implications for banking organizations. 

Current Conditions in Commercial Real Estate Markets 

Prices of existing commercial properties are estimated to have declined 35 to 40 

percent since their peak in 2007, and market participants expect further declines. 

Demand for commercial property has declined as job losses have accelerated, and 

vacancy rates have increased. The higher vacancy levels and significant decline in 

the value of existing properties have placed particularly heavy pressure on construction and development projects that generate no income until completion. Developers 

typically depend on the sales of completed projects to repay their outstanding loans, 

and with the volume of property sales at especially low levels and with prices depressed, the ability to service existing construction loans has been severely impaired. 

The negative fundamentals in the CRE property markets have caused a sharp deterioration in the credit performance of loans in banks’ portfolios and loans in commercial mortgage-backed securities (CMBS). At the end of the second quarter of 

2009, approximately $3.5 trillion of outstanding debt was associated with CRE, including loans for multifamily housing developments. Of this, $1.7 trillion was held 

on the books of banks and thrifts, and an additional $900 billion represented collateral for CMBS, with other investors holding the remaining balance of $900 billion. 

Also at the end of the second quarter, about 9 percent of CRE loans on banks’ books 

were considered delinquent, almost double the level of a year earlier.3 Loan performance problems were the most striking for construction and development loans, especially for those that finance residential development. More than 16 percent of all 

construction and development loans were considered delinquent at the end of the 

second quarter. 

Almost $500 billion of CRE loans will mature each year over the next few years. 

In addition to losses caused by declining property cash-flows and deteriorating conditions for construction loans, losses will also be boosted by the depreciating collateral value underlying those maturing loans. These losses will place continued pressure on banks’ earnings, especially those of smaller regional and community banks 

that have high concentrations of CRE loans. 

The current fundamental weakness in CRE markets is exacerbated by the fact 

that the CMBS market, which had financed about 30 percent of originations and 

completed construction projects, has remained virtually inoperative since the start 

of the crisis. Essentially no CMBS have been issued since mid-2008. New CMBS 

issuance came to a halt as risk spreads widened to prohibitively high levels in response to the increase in CRE-specific risk and the general lack of liquidity in structured debt markets. Increases in credit risk have significantly softened demand in 

the secondary trading markets for all but the most highly rated tranches of these 

securities. Delinquencies of mortgages backing CMBS have increased markedly in 

recent months. Market participants anticipate these rates will climb higher by the 

end of this year, driven not only by negative fundamentals but also by borrowers’ 

difficulty in rolling over maturing debt. In addition, the decline in CMBS prices has 
65 

4See Board of Governors of the Federal Reserve System, Division of Banking Supervision and 

Regulation (1991), ‘‘Interagency Examination Guidance on Commercial Real Estate Loans,’’ Supervision and Regulation Letter SR 91–24 (November 7), www.Federalreserve.gov/BoardDocs/ 

SRLetters/1991/SR9124.htm; and Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Federal Reserve Board, and Office of Thrift Supervision (1991), ‘‘Interagency Policy Statement on the Review and Classification of Commercial Real Estate Loans,’’ 

joint policy statement, November 7, www.Federalreserve.gov/BoardDocs/SRLetters/1991/ 

SR9124a1.pdf. 5See Board of Governors of the Federal Reserve System, Division of Banking Supervision and 

Regulation (2007), ‘‘Interagency Guidance on Concentrations in Commercial Real Estate,’’ Supervision and Regulation Letter SR 07 1 (January 4), www.Federalreserve.gov/boarddocs/srletters/ 

2007/SR0701.htm. 

generated significant stresses on the balance sheets of financial institutions that 

must mark these securities to market, further limiting their appetite for taking on 

new CRE exposure. 

Federal Reserve Activities to Help Revitalize Credit Markets 

The Federal Reserve, along with other government agencies, has taken a number 

of actions to strengthen the financial sector and to promote the availability of credit 

to businesses and households. In addition to aggressively easing monetary policy, 

the Federal Reserve has established a number of facilities to improve liquidity in 

financial markets. One such program is the Term Asset-Backed Securities Loan Facility (TALF), begun in November 2008 to facilitate the extension of credit to households and small businesses. 

Before the crisis, securitization markets were an important conduit of credit to the 

household and business sectors; some have referred to these markets as the ‘‘shadow 

banking system.’’ Securitization markets (other than those for mortgages guaranteed by the government) have virtually shut down since the onset of the crisis, 

eliminating an important source of credit. Under the TALF, eligible investors may 

borrow to finance purchases of the AAA-rated tranches of certain classes of assetbacked securities. The program originally focused on credit for households and small 

businesses, including auto loans, credit card loans, student loans, and loans guaranteed by the Small Business Administration. More recently, CMBS were added to the 

program, with the goal of mitigating a severe refinancing problem in that sector. 

The TALF has had some success. Rate spreads for asset-backed securities have 

declined substantially, and there is some new issuance that does not use the facility. 

By improving credit market functioning and adding liquidity to the system, the 

TALF and other programs have provided critical support to the financial system and 

the economy. 

Availability of Credit 

The Federal Reserve has long-standing policies in place to support sound bank 

lending and the credit intermediation process. Guidance issued during the CRE 

downturn in 1991 instructs examiners to ensure that regulatory policies and actions 

do not inadvertently curtail the availability of credit to sound borrowers.4 This guidance also states that examiners should ensure loans are being reviewed in a consistent, prudent, and balanced fashion to prevent inappropriate downgrades of credits. It is consistent with guidance issued in early 2007 addressing risk management 

of CRE concentrations, which states that institutions that have experienced losses, 

hold less capital, and are operating in a more risk-sensitive environment are expected to employ appropriate risk-management practices to ensure their viability.5

We are currently in the final stages of developing interagency guidance on CRE 

loan restructurings and workouts. This guidance supports balanced and prudent decisionmaking with respect to loan restructuring, accurate and timely recognition of 

losses and appropriate loan classification. The guidance will reiterate that classification of a loan should not be based solely on a decline in collateral value, in the absence of other adverse factors, and that loan restructurings are often in the best interest of both the financial institution and the borrower. The expectation is that 

banks should restructure CRE loans in a prudent manner, recognizing the associated credit risk, and not simply renew a loan in an effort to delay loss recognition. 

On one hand, banks have raised concerns that our examiners are not always taking a balanced approach to the assessment of CRE loan restructurings. On the other 

hand, our examiners have observed incidents where banks have been slow to acknowledge declines in CRE project cash-flows and collateral values in their assessment of the potential loan repayment. This new guidance, which should be finalized 

shortly, is intended to promote prudent CRE loan workouts as banks work with 

their creditworthy borrowers and to ensure a balanced and consistent supervisory 

review of banking organizations. 
66 

6See Board of Governors of the Federal Reserve System, FDIC, Office of the Comptroller of 

the Currency, and Office of Thrift Supervision (2008), ‘‘Interagency Statement on Meeting the 

Needs of Creditworthy Borrowers,’’ joint press release, November 12, www.Federalreserve.gov/ 

newsevents/press/bcreg/20081112a.htm. 

Guidance issued in November 2008 by the Federal Reserve and the other Federal 

banking agencies encouraged banks to meet the needs of creditworthy borrowers, in 

a manner consistent with safety and soundness, and to take a balanced approach 

in assessing borrowers’ ability to repay and making realistic assessments of collateral valuations.6 In addition, the Federal Reserve has directed examiners to be 

mindful of the effects of excessive credit tightening in the broader economy and we 

have implemented training for examiners and outreach to the banking industry to 

underscore these intentions. We are aware that bankers may become overly conservative in an attempt to ameliorate past weaknesses in lending practices, and are 

working to emphasize that it is in all parties’ best interests to continue making 

loans to creditworthy borrowers. 

Strengthening the Supervisory Process 

The recently completed SCAP of the 19 largest U.S. bank holding companies demonstrates the effectiveness of forward-looking horizontal reviews and marked an important evolutionary step in the ability of such reviews to enhance supervision. 

Clearly, horizontal reviews—reviews of risks, risk-management practices and other 

issues across multiple financial firms—are very effective vehicles for identifying 

both common trends and institution-specific weaknesses. The SCAP expanded the 

scope of horizontal reviews and included the use of a uniform set of stress parameters to apply consistently across firms. 

An outgrowth of the SCAP was a renewed focus by supervisors on institutions’ 

own ability to assess their capital adequacy—specifically their ability to estimate 

capital needs and determine available capital resources during very stressful periods. A number of firms have learned hard, but valuable, lessons from the current 

crisis that they are applying to their internal processes to assess capital adequacy. 

These lessons include the linkages between liquidity risk and capital adequacy, the 

dangers of latent risk concentrations, the value of rigorous stress testing, the importance of strong governance over their processes, and the importance of strong fundamental risk identification and risk measurement to the assessment of capital adequacy. Perhaps one of the most important conclusions to be drawn is that all assessments of capital adequacy have elements of uncertainty because of their inherent 

assumptions, limitations, and shortcomings. Addressing this uncertainty is one 

among several reasons that firms should retain substantial capital cushions. 

Currently, we are conducting a horizontal assessment of internal processes that 

evaluate capital adequacy at the largest U.S. banking organizations, focusing in particular on how shortcomings in fundamental risk management and governance for 

these processes could impair firms’ abilities to estimate capital needs. Using findings from these reviews, we will work with firms over the next year to bring their 

processes into conformance with supervisory expectations. Supervisors will use the 

information provided by firms about their processes as a factor—but by no means 

the only factor—in the supervisory assessment of the firms’ overall capital levels. 

For instance, if a firm cannot demonstrate a strong ability to estimate capital needs, 

then supervisors will place less credence on the firm’s own internal capital results 

and demand higher capital cushions, among other things. Moreover, we have already required some firms to raise capital given their higher risk profiles. In general, we believe that if firms develop more-rigorous internal processes for assessing 

capital adequacy that capture all the risks facing those firms—including under 

stress scenarios—and maintain adequate capital based on those processes, they will 

be in a better position to weather financial and economic shocks and thereby perform their role in the credit intermediation process. 

We also are expanding our quantitative surveillance program for large, complex 

financial organizations to include supervisory information, firm-specific data analysis, and market-based indicators to identify developing strains and imbalances that 

may affect multiple institutions, as well as emerging risks to specific firms. Periodic 

scenario analyses across large firms will enhance our understanding of the potential 

impact of adverse changes in the operating environment on individual firms and on 

the system as a whole. This work will be performed by a multidisciplinary group 

composed of our economic and market researchers, supervisors, market operations 

specialists, and accounting and legal experts. This program will be distinct from the 

activities of onsite examination teams so as to provide an independent supervisory 

perspective, as well as to complement the work of those teams. As we adapt our internal organization of supervisory activities to build on lessons learned from the cur-
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rent crisis, we are using all of the information and insight that the analytic abilities 

the Federal Reserve can bring to bear in financial supervision. 

Conclusion 

A year ago, the world financial system was profoundly shaken by the failures and 

other serious problems at large financial institutions here and abroad. Significant 

credit and liquidity problems that had been building since early 2007 turned into 

a full-blown panic with adverse consequences for the real economy. The deterioration in production and employment, in turn, exacerbated problems for the financial 

sector. 

It will take time for the banking industry to work through these challenges and 

to fully recover and serve as a source of strength for the real economy. While there 

have been some positive signals of late, the financial system remains fragile and key 

trouble spots remain, such as CRE. We are working with financial institutions to 

ensure that they improve their risk management and capital planning practices, 

and we are also improving our own supervisory processes in light of key lessons 

learned. Of course, we are also committed to working with the other banking agencies and the Congress to ensure a strong and stable financial system. 
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1FDIC Quarterly Banking Profile, Second Quarter 2009: http://www2.fdic.gov/qbp/2009jun/ 

qbp.pdf. 

PREPARED STATEMENT OF JOSEPH A. SMITH, JR. 

NORTH CAROLINA COMMISSIONER OF BANKS, 

ON BEHALF OF THE CONFERENCE OF STATE BANK SUPERVISORS

OCTOBER 14, 2009 

INTRODUCTION 

Good afternoon, Chairman Johnson, Ranking Member Crapo, and distinguished 

members of the Subcommittee. My name is Joseph A. Smith, Jr. I am the North 

Carolina Commissioner of Banks and the Chairman of the Conference of State Bank 

Supervisors (CSBS). 

Thank you for the opportunity to testify today on the condition of the banking industry. In the midst of a great deal of discussion about reform and recovery, it is 

very important to pause to assess the health of the industry and the factors affecting it, for good and ill. 

My testimony today will present the views of state bank supervisors on the health 

of the banking industry generally and the banks we oversee in particular—the overwhelming majority of which are independent community banks. The states charter 

and regulate 73 percent of the nation’s banks (Exhibit A). These banks not only 

compete with the nation’s largest banks in the metropolitan areas, but many are 

the sole providers of credit to less populated and rural areas (Exhibit B). We must 

remember 91 percent of this country’s banks have less than $1 billion in assets but 

share most of the same regulatory burdens and economic challenges of the largest 

banks which receive the greatest amount of attention from the Federal Government. 

Community and regional banks are a critical part of our economic fabric, providing 

an important channel for credit for consumers, farmers, and small businesses. 

I will address: the key challenges that state-chartered banks face, regulatory policies that we are pursuing to improve supervision and the health of the industry, 

and recommendations to improve the regulation of our banks and ultimately the 

health of the industry. 

CONDITION OF THE BANKING INDUSTRY 

While the economy has begun to show signs of improvement, there are still many 

areas of concern. Consumer confidence and spending remains low, deficit spending 

has soared, and unemployment rates continue to slowly tick upward. The capital 

markets crisis, distress in the residential and commercial real estate markets, and 

the ensuing recession have greatly weakened our nation’s banking industry. And despite recent positive developments, the banking industry continues to operate under 

very difficult conditions. While there are pockets of strength in parts of the state 

bank system, the majority of my fellow state regulators have categorized general 

banking conditions in their states as ‘‘gradually declining.’’ Not surprisingly, the 

health of banks is directly affected by the economic conditions in which they operate. Times of economic growth will usually be fueled by a banking industry with 

sufficient levels of capital, a robust and increasing volume of performing loans, 

ample liquidity, and a number of new market entrants, in the form of de novo institutions. Conversely, this recession is characterized by a banking industry marred by 

evaporating capital levels, deteriorating and increasingly delinquent loans, liquidity 

crunches, and a steady stream of bank failures. 

The Federal Deposit Insurance Corporation (FDIC) reports in its most recent 

Quarterly Banking Profile that the banking industry suffered an aggregate net loss 

of $3.7 billion in the second quarter of 2009. These losses were largely caused by 

the increased contributions institutions made to their loan-loss provisions to counter 

the rising number of non-performing loans in their portfolios and realized losses. 

Further, additional writedowns in the asset-backed commercial paper portfolios and 

higher deposit insurance assessments impacted banks’ earnings significantly.1

Across the country, my colleagues are experiencing deteriorating credit quality in 

their banks, which is straining earnings and putting extreme pressure on capital. 

Deterioration in credit quality is requiring greater examination resources as regulators evaluate a higher volume of loans. Concentrations in commercial real estate 

(CRE) loans in general, and acquisition, development, and construction (ADC) loans 

in particular, are posing the greatest challenge for a significant portion of the industry. This is an important line of business for community and regional banks. Banks 

with less than $10 billion in assets comprise 23 percent of total bank assets, but 

originate and hold 52 percent of CRE loans and 49 percent of ADC loans by volume. 

Reducing the concentrations that many of our institutions have in CRE lending is 
148 

an important factor in restoring them to health; however, it is our view that this 

reduction needs to be done in a way that does not remove so much credit from the 

real estate market that it inhibits economic recovery. Striking an appropriate balance should be our goal. 

Deteriorating credit quality has a direct and destructive effect on bank capital. 

Reduction in capital, in turn, has a direct and destructive effect on a bank’s liquidity, drying up its sources of funding from secondary sources, including capital markets, brokered deposits, home loan and bankers’ banks and the Federal Reserve. 

This drying up of liquidity has been a significant challenge for a substantial number 

of the failures. 

CAPITAL IS KING 

As we entered the financial crisis, we touted the overall strong capital base of the 

industry, especially compared to previous periods of economic stress. While this was 

true, banks are highly leveraged operations, and when losses materialize, capital 

erodes quickly. While this is true for all institutions, it is more pronounced in our 

largest banks. According to the FDIC, as of December 31, 2007, banks over $10 billion in assets had an average leverage capital ratio of 7.41 percent. This was 200 

basis points (b.p.) less than banks with assets between $1 billion and $10 billion; 

256 b.p. less than banks with assets between $100 million and $1 billion; and an 

astonishing 610 b.p. less than banks with assets less than $100 million. As the financial crisis was unfolding and the serious economic recession began, these numbers show our largest institutions were poorly positioned, leading to the extraordinary assistance by the Federal Government to protect the financial system. Even 

with this assistance, this differential continues today with the largest institutions 

holding considerably less capital than the overwhelming majority of the industry. 

Last year, the Federal Government took unprecedented steps to protect the financial system by providing capital investments and liquidity facilities to our largest 

institutions. Financial holding company status was conferred on a number of major 

investment banks and other financial concerns with an alacrity that was jaw-dropping. We trust the officials responsible took the action they believed necessary at 

that critical time. However, Federal policy has not treated the rest of the industry 

with the same expediency, creativity, or fundamental fairness. Over the last year, 

we have seen nearly 300 community banks fail or be merged out of existence, while 

our largest institutions, largely considered too big to fail, have only gotten bigger. 

State officials expect this trend to continue, with an estimated 125 additional unassisted, privately negotiated mergers due to poor banking conditions. 

Additional capital, both public and private, must be the building block for success 

for community and regional banks. While TARP has provided a source of capital for 

some of these institutions, the process has been cumbersome and expensive for the 

community and regional banks, whether they actually received the investment of 

funds or not. There has been a lack of transparency associated with denial of a 

TARP application, which comes in the form of an institution being asked to withdraw. This should of deep concern to Congress. If TARP is to be an effective tool 

to strengthen community and regional banks, the Treasury must change the viability standard. We should provide capital to institutions which are viable after the 

TARP investment. Expanded and appropriate access to TARP capital will go a long 

way to saving the FDIC and the rest of the banking industry a lot of money. To 

date, this has been a lost opportunity for the Federal Government to support community and regional banks and provide economic stimulus. 

There are positive signs private capital may be flowing into the system. For the 

6 months ending June 30, 2009, over 2,200 banks have injected $96 billion in capital. While capital injections were achieved for all sizes of institutions, banks with 

assets under $1 billion in assets had the smallest percentage of banks raising capital at 25 percent. 

There has been and, to our knowledge, there still is a concern among our Federal 

colleagues with regard to strategic investments in and acquisitions of banks, both 

through the FDIC resolution process and in negotiated transactions. While these 

concerns are understandable, we believe they must be measured against the consequence of denying our banks this source of capital. It is our view that Federal policy should not unnecessarily discourage private capital from coming off the sidelines 

to support this industry and in turn, the broader economy. 

SUPERVISION DURING THE CRISIS 

There are very serious challenges facing the industry and us as financial regulators. State regulators have increased their outreach with the industry to develop 

a common understanding of these challenges. Banks are a core financial intermediary, providing a safe haven for depositors’ money while providing the necessary 
149 

fuel for economic growth and opportunity. While some banks will create-and have 

created-their own problems by miscalculating their risks, it is no surprise that there 

are widespread problems in banks when the national economy goes through a serious economic recession. 

We will never be able, nor should we desire, to eliminate all problems in banks; 

that is, to have risk-free banking. While they are regulated and hold the public 

trust, financial firms are largely private enterprises. As such, they should be allowed to take risks, generate a return for shareholders, and suffer the consequences 

when they miscalculate. Over the last year, we have watched a steady stream of 

bank failures. While unfortunate and expensive, this does provide a dose of reality 

to the market and should increase the industry’s self-discipline and the regulators’ 

focus on key risk issues. In contrast to institutions deemed too big to fail, market 

discipline and enhanced supervisory oversight can result in community and regional 

banks that are restructured and strengthened. 

Recognizing the Challenges 

The current environment, while providing terrific challenges with credit quality 

and capital adequacy, has also brought an opportunity for us to reassess the financial regulatory process to best benefit our local and national economies. To achieve 

this objective, it is vital to step back and make an honest assessment of our regulated institutions, their lines of business, management ability, and capacity to deal 

with economic challenges. This assessment provides the basis for focusing resources 

to address the many challenges we face. 

With regard to financial institutions, as regulators we must do a horizontal review 

and engage in a process of ‘‘triage’’ that divides our supervised entities into three 

categories: 

• I. Strong 

• II. Tarnished 

• III. Weak 

Strong institutions have the balance sheets and management capacity to survive, 

and even thrive, through the current crisis. These institutions will maintain stability and provide continued access to credit for consumers. Further, these institutions will be well-positioned to purchase failing institutions, which is an outcome 

that is better for all stakeholders than outright bank failure. We need to ensure 

these institutions maintain their positions of strength. 

Tarnished institutions are under stress, but are capable of surviving the current 

crisis. These institutions are where our efforts as regulators can make the biggest 

difference. Accordingly, these institutions will require the lion’s share of regulatory 

resources. A regulator’s primary objective with these institutions should be to fully 

and accurately identify their risks, require generous reserves for losses, and develop 

the management capacity to work through their problems. We have found that 

strong and early intervention by regulators, coupled with strong action by management, has resulted in the strengthening of our banks and the prevention of further 

decline or failure. By coordinating their efforts, state and Federal regulators can 

give these banks a good chance to survive by setting appropriate standards of performance and avoiding our understandable tendencies to over-regulate during a crisis. 

Weak institutions are likely headed for failure or sale. While this outcome may 

not be imminent, our experience has shown that the sooner we identify these institutions, the more options we will have to seek a resolution which does not involve 

closing the bank. It simply is not in our collective best interest to allow an institution to exhaust its capital and to be resolved through an FDIC receivership, if such 

an action can be avoided. Institutions we believe are headed toward almost certain 

failure deserve our immediate attention. This is not the same as bailing out, or 

propping up failing institutions with government subsidies. Instead, as regulators 

our goal is an early sale of the bank, or at least a ‘‘soft landing’’ with minimal economic disruption to the local communities they serve and minimal loss to the Deposit Insurance Fund. 

AREAS REQUIRING ATTENTION 

This is the time for us to be looking forward, not backwards. We need to be working to proactively resolve the problems in the banking industry. To do this, we need 

to ensure our supervisory approach is fair and balanced and gives those banks 

which deserve it the chance to improve their financial positions and results of operations. The industry and regulators must work together to fully identify the scope 

of the problems. However, I believe we need to consider the response which follows 

the identification. We should be tough and demanding, but the response does not 
150 

need to send so many banks toward receivership. A responsive, yet reasonable approach, will take a great deal of time and effort, but it will result in less cost to 

the Deposit Insurance Fund and benefit communities and the broader economy in 

the long-run. I would like to highlight a few areas where I have concerns. 

Increase Access to Capital 

First, as discussed earlier, we need to allow capital to flow into the system. There 

is a significant amount of capital which is seeking opportunities in this market. We 

need to encourage this inflow through direct investments in existing institutions 

and the formation of new banks. To the extent that private investors do not themselves have bank operating experience or intend to dismantle institutions without 

consideration of the social and economic consequences, such shortcomings can and 

should be addressed by denial of holding company or bank applications or through 

operating restrictions in charters or regulatory orders. Where private equity groups 

have employed seasoned management teams and proposed acceptable business 

plans, such groups should be granted the necessary regulatory approvals to invest 

or acquire. While we cannot directly fix the capital problem, we should ensure the 

regulatory environment does not discourage private capital. 

Expedite Mergers 

Second, we need to allow for banks to merge, especially if it allows us to resolve 

a problem institution. Unfortunately, we have experienced too many roadblocks in 

the approval process. We need more transparency and certainty from the Federal 

Reserve on the process and parameters for approving mergers. To be clear, I am not 

talking about a merger of two failing institutions. Facilitating the timely merger of 

a weak institution with a stronger one is good for the system, good for local communities, and is absolutely the least cost resolution for the FDIC. 

Brokered Deposits 

Third, over the last several years the industry has explored more diversified funding, including the use of brokered deposits. Following the last banking crisis, there 

are restrictions for banks using brokered deposits when they fall below ‘‘well capitalized.’’ I appreciate the efforts of FDIC Chairman Bair in working to provide more 

consistency and clarity in the application of this rule. However, I am afraid the current approach is unnecessarily leading banks to fail. We allowed these banks to increase their reliance on this funding in the first place, and I believe we have a responsibility to assist them in gradually unwinding their dependency as they work 

to clean up their balance sheet. My colleagues have numerous institutions that 

could have benefited from a brokered deposit waiver granted by the FDIC. As noted 

above, many of the recent failures of community and regional banks have been the 

result of a sudden and precipitous loss of liquidity. 

Open Bank Assistance 

Fourth, the FDIC is seriously constrained in providing any institution with open 

bank assistance. We are concerned that this may be being too strictly interpreted. 

We believe there are opportunities to provide this assistance which do not benefit 

the existing shareholders and allows for the removal of bank management. This is 

a much less disruptive approach and I believe will prove to be much less costly for 

the FDIC. The approach we suggest was essentially provided to Citibank and Bank 

of America through loan guarantees without removing management or eliminating 

the stockholders. As discussed previously, we believe that the Capital Purchase Program under TARP can be a source of capital for transactions that restructure banks 

or assist in mergers to the same effect. We are not suggesting that such support 

be without conditions necessary to cause the banks to return to health. 

Prompt Corrective Action 

Finally, Congress should also investigate the effectiveness of the Prompt Corrective Action (PCA) provisions of the Federal Deposit Insurance Corporation Improvement Act in dealing with problem banks. We believe there is sufficient evidence that 

the requirements of PCA have caused unnecessary failures and more costly resolutions and that allowing regulators some discretion in dealing with problem banks 

can assist an orderly restructuring of the industry. 

LOOKING FORWARD 

There will be numerous legacy items which will emerge from this crisis designed 

to address both real and perceived risks to the financial system. They deserve our 

deliberate thought to ensure a balanced and reasoned approach which provides a 

solid foundation for economic growth and stability. 
151 

The discussions around regulatory reform are well underway. We would do well 

to remember the instability of certain firms a year ago which put the U.S. financial 

system and economy at the cliff’s edge. We must not let the bank failures we are 

seeing today cloud the real and substantial risk facing our financial system—firms 

which are too big to fail, requiring extraordinary government assistance when they 

miscalculate their risk. 

We need to consider the optimal economic model for community banks, one that 

embraces their proximity to communities and their ability to engage in high-touch 

lending. However, we must ensure lower concentrations, better risk diversification, 

and improved risk management. We need to find a way to ensure banks are viable 

competitors for consumer finance and ensure they are positioned to lead in establishing high standards for consumer protection and financial literacy. 

We must develop better tools for offsite monitoring. The banking industry has a 

well established and robust system of quarterly data reporting through the Federal 

Financial Institutions Examination Council’s Report of Condition and Income (Call 

Report). This provides excellent data for use by all regulators and the public. We 

need to explore greater standardization and enhanced technology to improve the 

timeliness of the data, especially during times of economic stress. 

Over the last several years, the industry has attracted more diversified sources 

of funding. This diversification has improved interest rate risk and liquidity management. Unfortunately, secured borrowings and brokered deposits increase the cost 

of resolution to the FDIC and create significant conflicts as an institution reaches 

a troubled condition. We need to encourage diversified sources of funding, but ensure it is compatible with a deposit insurance regime. 

We need to consider how the Deposit Insurance Fund can help to provide a countercyclical approach to supervision. We believe Congress should authorize the FDIC 

to assess premiums based on an institution’s total assets, which is a more accurate 

measure of the total risk to the system. Congress should revisit the cap on the Fund 

and require the FDIC to build the Fund during strong economic times and reduce 

assessments during period of economic stress. This type of structure will help the 

entire industry when it is most needed. 

CONCLUSION 

The banking industry continues to face tremendous challenges caused by the poor 

economic conditions in the United States. To move through this crisis and achieve 

economic stability and growth, Members of Congress, state and Federal regulators, 

and members of the industry must coordinate efforts to maintain effective supervision, while exercising the flexibility and ingenuity necessary to guide our industry 

to recovery. 

Thank you for the opportunity to testify today, and I look forward to any questions you may have. 
152 
153 
154 

1 NASCUS is the professional association of the 48 state credit union regulatory and territorial 

agencies that charter and supervise the nation’s 3,100 state-chartered credit unions. 2 As of June 30, 2009. 

PREPARED STATEMENT OF THOMAS J. CANDON 

DEPUTY COMMISSIONER, VERMONT DEPARTMENT OF BANKING, INSURANCE, 

SECURITIES, AND HEALTH CARE ADMINISTRATION

ON BEHALF OF THE NATIONAL ASSOCIATION OF STATE CREDIT UNION SUPERVISORS

OCTOBER 14, 2009 

Introduction 

Honorable Chairman Johnson, Ranking Member Crapo and the distinguished 

members of the Financial Institutions Subcommittee of the Senate Banking, Housing and Urban Affairs Committee, thank you for the opportunity to testify before 

this Subcommittee on the State of the Banking Industry. I am Thomas J. Candon, 

Deputy Commissioner of Banking and Securities for the Vermont Department of 

Banking, Insurance, Securities and Health Care Administration. I am pleased to be 

here on behalf of state credit union regulators as Chairman of the National Association of State Credit Union Supervisors 1 (NASCUS). In this prepared testimony, I 

will share state credit union regulators’ perspectives on the condition of state-chartered credit unions and areas for reform. 

NASCUS has been committed to enhancing state credit union supervision and advocating for a safe and sound state credit union system since its inception in 1965. 

NASCUS is the sole organization dedicated exclusively to the promotion of the dual 

chartering system and advancing the autonomy and expertise of state credit union 

regulatory agencies. 

The state credit union system is 100 years old. Today, there are 3,065 state-char- tered credit unions with a combined $404 billion in assets.2 State-chartered credit 

unions represent 40 percent of the nation’s nearly 7,700 credit unions. 

At this hearing, the Subcommittee is assessing the state of financial institutions, 

areas of concern as well as capital and lending needs. In this testimony, I will detail 

information from state regulators on the following: 

• Condition of state-chartered credit unions 

• Corporate credit union impact 

• Credit union capital needs 

• Regulatory considerations for member business lending 

• Trends and regulatory response 

• Value and strength of state supervision 

Condition of state-chartered credit unions 

Like all financial institutions, state credit unions have been adversely affected by 

the economic downturn. However, at this point, state natural person credit unions 

remain generally healthy and continue to serve the needs of their members and 

their communities. For the most part, natural person credit unions did not engage 

in many of the practices that have precipitated the current market downturn. 

Nationally, the average credit union net worth is down to 10.03 percent, with 96 

percent of all federally insured credit unions having more than 7 percent in capital 

as of June 30, 2009. Further, the percentage of delinquent loans is 1.58 percent for 

all credit union loans. 

State-chartered credit unions in my state of Vermont have the capability to lend 

due to an increase in deposits that we attribute to a flight to safety. Consumer loans 

are available to members although underwriting continues to be based on a member’s ability to repay. At this time, Vermont credit unions do not make many member business loans and have nominal commercial real estate loans on their balance 

sheets. Our regulatory focus is on the amount of capital held by some of our credit 

unions and the impact of the growing unemployment picture on delinquencies. 

The capital of Vermont credit unions is affected by the growth of deposits which 

were up 24.73 percent in Vermont as of June 30, 2009, and the impact of the corporate credit union losses (which I will discuss later). Income is also being reduced 

as margins are squeezed and credit union members are struggling to make loan 

payments. 

In Vermont, our small credit unions like many around the country are not only 

affected by a downturn in the economy but also by increasing regulatory burden. 

We continue to see mergers as long-time managers retire and volunteer boards cannot keep up with the increased demands. As state regulators we monitor our credit 
155 

unions closely. If there is any sign of distress, we have an examiner communicating 

with the credit union to make sure we understand what needs to be done to correct 

the problems. 

As the Subcommittee knows, the effect of the economy on financial institutions 

varies from region to region. Some regions are weathering significant impacts from 

the destabilized real estate market, while others are addressing more localized economic issues. In many cases, state regulators are concerned about unemployment 

and its impact on members’ ability to meet their obligations. State regulators are 

also concerned about the growing number of delinquencies, charge-offs and pressures on earnings, especially in smaller state-chartered credit unions. While loan delinquency and net charge-offs have generally increased for state-chartered credit 

unions, state regulators indicate that the levels remain manageable. 

State regulators also report increased scrutiny on consumer credit products, including auto loans, credit cards and other consumer credit portfolios given the nation’s economic condition. State credit union regulators are cognizant of credit 

unions’ future financial performance as commercial credit problems begin to affect 

consumer credits. The weak economy creates a tightening of commercial credit, an 

issue being closely monitored by state regulators. 

Some states, including my home state of Vermont, have not experienced the fallout from commercial or subprime lending as our state-chartered credit unions did 

not engage in those activities. State regulators continue to encourage their credit 

unions to exercise sound underwriting, proper risk management and due diligence, 

the elements that have kept credit unions in a better position throughout this economic downturn. Further, state regulators are monitoring red flags closely, fully utilizing offsite monitoring and using early warning systems to detect risk. 

The growing trend toward consolidation is also on the minds of state regulators 

as credit union mergers continue to occur, both voluntarily and for regulatory purposes. As economic pressures persist, finding suitable merger partners may become 

more difficult. State regulators recognize this dilemma and see merger issues as an 

ongoing concern in 2010. 

In addition, growth is an issue state regulators are paying close attention to in 

today’s environment. The National Credit Union Administration (NCUA) reported 

in its Financial Trends in federally Insured Credit Unions for January–June 2009 

an annualized asset growth rate of 14.53 percent. This growth gives rise to concerns 

about interest rate risk and the need to ensure quality asset/liability and balance 

sheet management among credit unions. 

Corporate Credit Union Impact 

As I noted earlier, one of the issues affecting both state and Federal credit unions 

is the impact of problems in the corporate credit union network. Allow me to elaborate. In addition to direct economic pressures, credit unions are addressing indirect 

economic pressures by way of the impact of losses from corporate credit unions. The 

deterioration of asset-backed securities held by two Federal corporate credit unions 

(U.S. Central Corporate Federal Credit Union and Western Corporate Federal Credit Union) and their consequent conservatorship by the NCUA have resulted in considerable balance sheet impact on natural person credit unions. 

For the first time in nearly 20 years, the NCUA Board approved a credit union 

premium in September 2009 with the assessment of 0.15 percent of insured shares. 

The premium will both restore the National Credit Union Share Insurance Fund 

(NCUSIF) equity to 1.30 percent and begin to repay a portion of the Temporary Corporate Credit Union Stabilization Fund borrowings from the U.S. Treasury. 

State regulators, in consultation with Federal regulators, are working to address 

the impact of corporate losses and to make regulatory improvements to mitigate recurrence. As the NCUA develops its proposed rule for regulation of corporate credit 

unions, state regulators continue to stress the following principles: 

• Enhance supervision and tighten regulatory standards 

• Properly assess risk problems 

• Preserve equal opportunity for all corporates to compete as long as they remain 

safe and sound and retain the support of their members 

• Guard against preemption of state authority and homogenization of the corporate system 

State regulators have also cautioned the NCUA against regulation that would unnecessarily or adversely impact safe and sound corporate credit unions that have 

properly managed their investments and remain fully supported by their members. 

NCUA has been working cooperatively with state regulators to institute revisions 

to the agency’s Part 704 corporate credit union regulations to strengthen the safety 
156 

and soundness of the corporate system. Regulators should continue to focus on ensuring any credit union, natural person or corporate, has robust risk management 

and mitigation policies in place to balance its investment portfolios. Such policies 

should include adequate reserves, requisite expertise, meaningful shock testing and 

valuation mechanisms as well as concentration limits. NASCUS believes there is no 

question that after recent events corporate credit unions must retain higher capital 

reserves. NCUA should work with NASCUS and state regulators to develop more 

comprehensive capital requirements, including risk-based capital. 

The regulatory capital program for corporate credit unions should consider an institution’s status as a wholesale or retail corporate, its mix of products and services 

(investment, payment systems, pass through, etc.) and establish parameters of actions for state and Federal regulators if capital falls below defined thresholds. 

Capital is important to both the corporate credit union system and the natural 

person credit unions that support the corporate credit unions. During the corporate 

stabilization process, supplemental capital may have mitigated some of the unintended consequences to net worth categories at natural person credit unions. Further, access to a risk-based capital system would foster safety and soundness for the 

entire credit union system. 

Credit Union Capital Needs 

The majority of credit unions are weathering conditions today; however, as stated 

previously, credit unions’ earnings are suffering and credit unions are losing money. 

We need to act now to ensure credit unions remain as safe and sound as possible. 

NASCUS has long supported comprehensive capital reform for credit unions and believes that given the current economic climate, reform in this area is critical and 

timely. Credit unions need more ways to raise capital, notably access to supplemental capital. NASCUS continues to encourage the Senate Banking Committee to 

consider credit union capital reform as part of its financial reform efforts. 

Unlike other financial institutions, credit union access to capital is limited to reserves and retained earnings from net income. Since net income is not easily increased in a fast-changing environment, state regulators recommend additional capital-raising capabilities for credit unions. Access to supplemental capital will enable 

credit unions to respond proactively to changing market conditions, enhancing their 

future viability and strengthening their safety and soundness. Supplemental capital 

would serve as an extra layer of protection for the credit union deposit insurance 

fund as well. 

Allowing credit unions access to supplemental capital with regulatory approval 

and robust oversight will improve their ability to react to market conditions, grow 

safely into the future and serve their members in this challenged economy. It would 

also provide a tool for credit unions to use if they face declining net worth or liquidity needs. We feel strongly that now is the time to permit this important change. 

NASCUS follows several guiding principles in our quest for supplemental capital 

for credit unions. First, a capital instrument must preserve the not-for-profit, mutual, member-owned and cooperative structure of credit unions. Next, it must provide for full disclosures, investor protection and robust safeguards. Prudential safety 

and soundness requirements must be maintained for these investments and supplemental capital must preserve credit unions’ tax-exempt status. Finally, regulatory 

approval would be required before a credit union could access supplemental capital. 

It is NASCUS’ studied belief that a change to the Federal Credit Union Act could 

provide this valuable tool to the credit union system without altering the not-forprofit, mutual, cooperative structure of credit unions as tax exempt member owned 

financial institutions. We realize that supplemental capital will not be appropriate 

for every credit union, nor would every credit union need access to supplemental 

capital. This is why NASCUS supports regulator approval as a pre-condition for 

credit unions issuing supplemental capital. 

A task force of NASCUS state regulators is currently studying supplemental capital for credit unions with the NCUA. This regulatory group is researching the appropriate regulatory parameters for supplemental capital for credit unions. 

As this Subcommittee addresses regulatory reform and other legislation this fall, 

NASCUS encourages favorable consideration of access to supplemental capital for 

credit unions. 

Regulatory Considerations for Member Business Lending 

Credit union member business lending, when conducted within proper regulatory 

controls, has proved beneficial for credit unions, their members, and their communities. However, while some credit unions are actively engaged in member business 

lending, many are not. As Congress considers changes to credit unions’ member 

business lending capabilities, state regulators will work with the NCUA in its capac-
157 

ity as the insurer to build regulatory parameters for proper oversight through the 

examination and supervision process. Further, credit unions must have a thorough 

understanding of member business lending and be diligent in their written policies, 

underwriting and controls for the practice to be conducted in a safe and sound manner. From a prudential regulator view, an arbitrary cap on member business lending 

is less important than proper underwriting and thorough reporting of all business 

loans. 

Trends and Regulatory Response 

I would like to respond to the Subcommittee’s request for information regarding 

developing trends, concerns and state regulatory responses to today’s challenges. 

Rising unemployment continues to be a concern and we expect that it will continue 

to negatively impact state credit unions well into 2010 as delinquencies and bankruptcies continue to increase. 

Some state regulators have seen a marked increase in loan delinquencies and net 

charge-offs at June 2009; however, the levels remain manageable. Earnings pressures continue so credit unions are seeking ways to reduce overhead expenses. Loan 

demand has slowed somewhat in the mid-to smaller credit unions; a contrast to the 

increased indirect lending activities experienced in the larger credit unions. State 

regulators are closely monitoring both lending and investment activities within their 

credit unions and continue to stress the importance of sound underwriting and due 

diligence at the board level. State regulators also continue to supervise their institutions closely through offsite monitoring and onsite examinations and visitations. 

Credit unions need to understand their portfolio makeup and the impact that an 

increasing rate environment will have on their institutions. 

Another economic stressor affecting small credit unions is the uncertainty of losing their core field of membership if comprised of select employee groups. Because 

some small credit unions still rely on one or two employers for their members, if 

those businesses do not survive, the credit union will not survive either. 

Value and Strength of State Supervision 

In this challenged economic environment, state regulators have demonstrated the 

importance of local supervision of state-chartered institutions and the value of a 

dual regulatory regime. State regulators are properly tuned into both their institutions and the specific needs of local consumers. Further, state regulators have the 

expertise to identify risk areas and take enforcement actions where necessary. With 

respect to consumer protection, state regulators are directly accountable to Governors and state legislatures, who in turn are directly accountable to their consumer 

citizens. It is for this reason that many states have always emphasized consumer 

protection along with safety and soundness in financial services oversight. As regulatory modernization efforts are considered by the Senate Banking Committee, we 

encourage you to retain state supervision and uphold state authority. Further, we 

ask you to recognize the essential value of dual chartering to financial institution’s 

ability to innovate. 

Finally, as we talk about dual chartering, I wanted to note our regulatory partners, the National Credit Union Administration. In my state of Vermont, all of my 

credit unions are federally insured, and therefore subject to share insurance oversight from NCUA in addition to state safety and soundness and compliance regulation and supervision. We work extremely well with NCUA, and I believe our strong 

cooperative relationship has contributed substantially to the stability of the credit 

union system in my region. Indeed, this cooperative relationship between state regulators and the NCUA exists throughout the Nation as well. 

NASCUS would be pleased to provide any additional information you deem appropriate as you work through these matters. While the current economic climate has 

an unquestionable adverse impact on the state credit union system, I remain confident that the generally sound management of credit unions combined with ongoing 

vigilant state regulatory oversight has enabled the credit union system to prudently 

meet their members’ needs. Thank you for your attention. 
158 

RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO 

FROM SHEILA C. BAIR 

Q.l. According to a recent New York Times article, about $870 billion, or roughly half of the industry’s $1.8 trillion of commercial 

real estate loans, now sit on the balance sheet of small and medium sized banks. To what extent has TALF encouraged capital to 

enter the commercial real estate market and what other step 

should regulators be taking to address this problem? 

A.l. Small and medium-sized financial institutions hold a significant dollar amount of commercial real estate loans on their balance 

sheets. Many of these smaller institutions were not active in the 

commercial real estate mortgage securitization market because of 

the comparatively small dollar amount of the loans and the nature 

of customer-focused relationships in community banking. Therefore, we do not believe the TALF has had a significant effect on the 

availability of credit for smaller commercial real estate loans. 

In terms of encouraging commercial real estate lending, the Federal banking agencies issued a policy statement on October 30, 

2009, titled Prudent Commercial Real Estate Loan Workouts. The 

Statement encourages banks to continue making good loans to commercial real estateborrowers and work with borrowers experiencing 

difficulties in their repayment capacity because of the economic 

downturn. 

The TALF was designed to increase credit availability for businesses and consumers by facilitating renewed issuance of securities 

backed by loans to consumers and businesses at more normal interest rate spreads. Based on recent TALF transactions involving commercial real estate mortgage loans, the program appears to have 

encouraged capital to enter the securitization market. As the Federal Reserve Bank of New York is facilitating the TALF program, 

the Senator may want to consult with the Reserve Bank on the 

program’s performance and success in encouraging capital to return 

to the commercial real estate market. 

Q.2. How will FASB’s new rules on off-balance sheet accounting 

impact financial institution’s ability to lend and how do you intend 

to implement the changes? 

A.2. Following publication of the Notice of Proposed Rulemaking on 

September 15, 2009, the bank regulatory agencies received 41 comments from banks, bank holding companies, banking industry associations, mortgage companies, investment and asset management 

firms, and individuals. A number of commenters indicated that implementation of FAS 166 and FAS 167 without changes to the 

Agencies’ risk-based capital rules would negatively impact financial 

markets and curtail lending due to higher regulatory capital requirements resulting from the consolidation of significant amounts 

of assets onto banking organizations’ balance sheets. Commenters 

also argued that such implementation would inappropriately align 

capital requirements with GAAP’s control-based approach to consolidation, in contrast to the credit risk focus of the Agencies’ riskbased capital rules. The commenters overwhelmingly supported a 

delay or phase-in of the regulatory capital requirements resulting 

from the implementation of FAS 166 and FAS 167. 
159 

In response the FDIC, working with the other Federal bank regulatory agencies, developed a final rule to better align regulatory 

capital requirements with the actual risks of certain exposures. 

Banks affected by the new accounting standards generally will be 

subject to higher minimum regulatory capital requirements. The 

final rule provides an optional delay and phase-in for a maximum 

of 1 year for the effect on risk-based capital and the allowance for 

loan and lease losses related to the assets that must be consolidated as a result of the accounting change. The final rule also 

eliminates the risk-based capital exemption for asset-backed commercial paper assets. The transitional relief does not apply to the 

leverage ratio or to assets in conduits to which a bank provides or 

has provided implicit support. 

The Final Rule was passed by the FDIC Board of Directors on 

December 15, 2009. The rule provides temporary relief from riskbased measures in order to avoid abrupt adjustments that could 

undermine or complicate government actions to support the provision of credit to U.S. households and businesses in the current economic environment. Banks will be required to rebuild capital and 

repair balance sheets to accommodate the new accounting standards by the beginning of 2011. The optional delay and phase-in provides capital relief to ease the impact of the accounting change on 

bank’s regulatory capital requirements, and enable banks to maintain consumer lending and credit availability as they adjust their 

business practices to the new accounting rules. 

RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO 

FROM JOHN DUGAN 

Q.l. According to a recent New York Times article, about $870 bil- lion, or roughly half of the industry’s $1.8 trillion of commercial 

real estate loans, now sit on the balance sheet of small and medium sized banks. To what extent has TALF encouraged capital to 

enter the commercial real estate market and what other steps 

should regulators be taking to address this problem? 

A.l. The Federal Reserve’s Term Asset-Backed Securities Loan Facility (TALF) is intended to help make credit available to consumers and businesses by facilitating the issuance of asset-backed 

securities (ABS) and by improving the conditions for ABS more 

generally. Until recently, most of the financing conducted with 

TALF facilities has been concentrated in automobile and credit 

card ABS securities. The use of TALF to help restart the commercial mortgage-backed securities (CMBS) markets has lagged due to 

the complexity and level of due diligence required for these types 

of transactions. 

The use of the TALF program to assist the CMBS market took 

a positive step forward on November 16, 2009, when U.S. mall 

owner Developers Diversified Realty Corp sold $400 million of securities with the help of TALF financing. The $323 million TALF eligible AAA-rated portion was priced at under 4 percent, a much better rate than originally anticipated. This issuance is indicative of 

a key potential benefit of CMBS TALF: it provides a reasonable 

cost for senior debt, allowing liquidity to flow back into the market. 

However, it does not by itself solve the problem of overleveraged 
160 

borrowers. Since TALF financing is only available for AAA-rated 

debt, it would likely not directly benefit many of the problem borrowers sitting on the books of the banks today. However, there is 

an indirect benefit in that it provides market liquidity. Investors 

will likely use this initial deal as a benchmark, which could encourage other capital into the commercial real estate market. Because 

of this potential benefit, many market participants would like to 

see the current deadlines for the TALF program extended beyond 

the current deadlines of June 30, 2010, for newly issued CMBS and 

March 31, 2010, for legacy CMBS (i.e., deals issued before 1/1/09). 

Although there has been some modest improvement in liquidity 

within the CMBS market, the underlying fundamentals for many 

commercial real estate segments are still weak with delinquency, 

nonaccrual, and loss levels still increasing. Ultimately, the credit 

fundamentals of the industry need to stabilize in order for investors, bankers, and borrowers to fully understand pricing of commercial real estate assets. 

Banking regulators have a limited ability to directly encourage 

capital investment into the commercial real estate industry. We are 

mindful, however, that our actions must not put up unreasonable 

barriers to take flow of capital. At the OCC, we are encouraging 

bankers to work with their borrowers, and we continue to stress to 

examiners the need to take a measured, balanced approach when 

evaluating loan and borrower performance in this economic environment. We have stressed that we expect and encourage bankers 

to work with borrowers who may be facing financial difficulty, and 

to extend new credit to creditworthy borrowers when these actions 

are done in a prudent and safe and sound manner. In an effort to 

promote clarity and consistency in the industry, the OCC, in conjunction with the other Federal banking agencies and the FFIEC’s 

State Liaison Committee, recently issued a Policy Statement on 

Prudent Commercial Real Estate (CRE) Loan Workouts. The policy 

statement reiterates the agencies’ view that prudent CRE loan 

workouts are often in the best interest of the financial institution 

and the borrower, and establishes clear regulatory expectations for 

the industry when working with borrowers. The statement notes 

that examiners should not criticize banks for engaging in an effective workout program even if the restructured loan has a weakness 

that results in an adverse credit classification. The statement also 

reiterates our policy that loans should not be classified simply because the underlying values have declined to amounts that are less 

than the current loan balance. Instead, classifications must be 

based on an analysis of the borrower’s ability and capacity to 

repay. To help promote greater consistency both within and across 

the agencies in making such determinations, the policy statement 

provides real world examples that our examiners are seeing, and 

provides guidance on when classification and write-downs are and 

are not warranted. 

Q.2. How will FASB’s new rules on off-balance sheet accounting 

impact financial institution’s ability to lend, and how do you intend 

to implement the changes? 

A.2. Upon implementing FAS 166 and FAS 167, banking organizations will be required to consolidate certain assets and liabilities 
161 

1 A VIE is a business structure that allows an investor to hold a controlling interest in the 

entity, without that interest translating into possessing enough voting privileges to result in a 

majority. VIEs generally are thinly capitalized entities and include many ‘‘special purpose entities’’, or ‘‘SPEs.’’ 2The NPR proposed the following three changes to the agencies regulatory capital rules: (1) 

eliminate provisions in the agencies’ risk-based capital rules that allow banking organizations 

to exclude consolidated asset-backed commercial paper (ABCP) program assets from risk-weighted assets and instead assess a risk-based capital requirement against contractual exposures of 

the organization to such ABCP programs (ABCP exclusion); (2) eliminate a provision in the riskbased capital rules that excludes from tier 1 capital the minority interest in a consolidated 

ABCP programs subject to the ABCP exclusion; and (3) add a new reservation of authority for 

the agencies’ risk-based capital rules to permit a banking organization’s primary Federal supervisor to treat entities not consolidated under GAAP as if they were consolidated for risk-based 

capital purposes, commensurate with the risk relationship of the banking organization to the 

entity. 

that are currently held in variable interest entities (VIEs)1 that 

these organizations do not consolidate under current generally accepted accounting principles (GAAP) standards. Certain banking 

organizations have reported that the consolidation of variable interest entities will result in a significant increase in assets reported 

on-balance sheet at the time the new accounting standards become 

effective, which will be January 1, 2010, for banking organizations 

with a calendar year end. Moreover, except for VIEs that a banking 

organization consolidates at fair value, consolidation will require 

the banking organization to recognize an allowance for loan and 

lease losses for loans held in consolidated VIEs. 

On September 16, 2009, the Federal banking agencies (Agencies) 

published in the Federal Register a notice of proposed rulemaking 

(NPR) regarding the effect of the accounting changes under FAS 

166 and FAS 167 would have on capital requirements under the 

regulatory capital rules. The NPR noted that banking organizations 

had provided non-contractual support to VIEs that they sponsored 

in order to prevent senior securities in the structure from being 

downgraded, thereby mitigating reputational risk and the associated alienation of investors, and preserving access to cost-effective 

funding. In light of these actions taken by banking organizations, 

the NPR stated that the Agencies believe that the broader accounting consolidation requirements of FAS 166 and FAS 167 will result 

in a regulatory capital treatment that more appropriately reflects 

the risks to which banking organizations are exposed. For these 

and other reasons, the NPR did not propose changing the regulatory capital rules to mitigate the effect of FAS 166 and FAS 167 

on banking organizations’ minimum regulatory capital requirements.2

Before issuing the NPR, the Agencies carefully considered the 

probable effect on banking organizations’ financial regulatory capital ratios and financial condition that will result from implementing FAS 166 and FAS 167. Among other sources, the Agencies 

considered information obtained through the Supervisory Capital 

Assessment Program (SCAP)—the recent stress test of the nineteen 

largest U.S. banking organizations. The SCAP directly considered 

the likely on-boarding of assets resulting from changes in accounting standards in the assessment of risk-weighted assets and the associated ALLL needs of the stress-tested banks. Moreover, the NPR 

sought information and comments on a number of questions, including the effect of the accounting changes on banking organizations’ financial position and lending, as well as the effect on finan-
162 

3Determining whether a company is required to consolidate a VIE under FAS 167 depends 

on a qualitative analysis of whether the company has a ‘‘controlling financial interest’’ in the 

VIE. A company has a controlling financial interest if it has (1) the ability to direct matters 

that most significantly impact the activities of a VIE and (2) either the obligation to absorb 

losses of the VIE that could be significant to the VIE, or the right to receive benefits from the 

VIE that potentially could be significant to the VIE, or both. 

cial markets. The NPR also solicited comments on whether there 

are significant costs or burdens associated with implementing FAS 

166 and FAS 167, and whether the Agencies should consider a 

phase-in of the capital requirements that would result from the 

GAAP changes. 

Based on an analysis of available information, including comments received on the NPR, the Agencies have finalized work on 

this rulemaking and expect to publish a final rule in the Federal 

Register shortly. The Agencies have long maintained that banking 

organizations should hold capital commensurate with the level and 

nature of the risks to which they are exposed. The Agencies use 

risk-based capital rules, supplemented by a leverage capital rule 

(collectively, regulatory capital rules) to evaluate capital adequacy 

of banking organizations. In the regulatory capital rules, the Agencies use GAAP as the initial basis for determining whether an exposure is treated as an on- or off-balance sheet asset. In the final 

rule, the Agencies continue to make use of GAAP concepts within 

the regulatory capital regime by recognizing VIEs consolidated 

under FAS 167, and the risks associated with those assets, in their 

risk-based capital ratios. However, in order to avoid abrupt adjustments that could undermine or complicate government actions to 

support the provision of credit to U.S. households and businesses 

in the current economic environment, the Agencies are providing 

banking organizations with an optional two-quarter implementation delay followed by an optional two-quarter partial implementation of the effect of FAS 167 on risk-weighted assets and ALLL includable in tier 2 capital. 

During this rulemaking process, the Agencies have determined 

that while regulatory capital ratios at banking organizations most 

effected by implementation of FAS 166 and FAS 167 would decline, 

those ratios would remain significantly above regulatory minimums 

subsequent to the implementation of FAS 166 and FAS 167. In addition, the Agencies continue to believe that the new GAAP consolidation standards of FAS 167 more closely align the risk banking 

organizations face with respect to VIEs with which they are involved than current GAAP standards.3 The Agencies are aware, 

however, that several government programs supporting the 

securitization market are scheduled to terminate in the first quarter of 2010. In addition, Congress and the regulatory agencies are 

considering a number of legislative and regulatory changes that 

would affect the securitization activities. Given that the Agencies 

cannot precisely assess the combined effect of these changes on the 

securitization market, and because securitization activities remain 

an important source of funding for banking organizations, the 

Agencies are providing banking organizations a delay or phase-in 

period in the final rule. 

Q.3. What is the impact of the proposed action by the Office of the 

Comptroller of the Currency and the Office of Thrift Supervision to 
163 

end ‘‘no payment’’ deferred interest financing promotions on consumers and businesses? I understand the impact to be very large 

and I would appreciate the agencies working to clarify that ‘‘no 

payment’’ deferred interest financing promotions can be used in the 

future albeit perhaps with revised disclosures and marketing. 

A.3. In January 2003, the OCC, the Office of Thrift Supervision, 

the Board of Governors of the Federal Reserve System, and the 

Federal Deposit Insurance Corporation (the Agencies), issued the 

Credit Card Account Management and Loss Allowance Guidance 

(AMG). This guidance addressed regulatory concerns with the easing of minimum payment requirements as well as concerns with 

other account management practices. The AMG states, in part, that 

the Agencies expect lenders to require minimum payments that 

will amortize the current balance of the account over a reasonable 

period. The guidance does not differentiate between general purpose and private label card programs. 

The receipt of regular monthly payments is important in consumer lending for several reasons. For borrowers, well designed 

payment structures promote a fundamental understanding of their 

debt burden in terms of monthly cash-flow and total income. Regular, budgeted payments help avoid the potential pitfalls associated 

with payment shock when payments begin or significantly increase 

under the loan amortization schedule. Regular payments also allow 

borrowers to demonstrate to existing and prospective lenders the 

willingness and capacity to repay their debts while systematically 

reducing those debts. 

For lenders, regular payments are an efficient way to monitor 

borrowers’ willingness and ability to repay without the operational 

expense associated with requiring ongoing payment capacity information. Regular payment streams also allow the identification of 

early warning measurements such as delinquencies, roll rates, payment rates, and credit scores to be effective. Furthermore, they 

help lenders manage Portfolio risk by providing important inputs 

into the determination of adequate capital and reserve levels. 

On June 18, 2009, the OCC issued a Supervisory Memorandum 

to remind our examiners that the increased use of ‘‘No Payment’’ 

programs being offered by banks, and their retail partners, are not 

consistent with the AMG. We asked our examiners to ensure that 

national banks cease any ‘‘No Payment’’ programs by February 22, 

2010. This gives national banks, and their retail partners, time to 

make necessary changes and coincides with the implementation 

date for other changes dictated by the Credit CARD Act. 

As a matter of clarification, the OCC does not object to ‘‘No Interest’’ programs. These promotions are very attractive to consumers 

and often provide real, tangible benefits. However, the OCC believes that any benefits associated with ‘‘No Payment’’ programs 

are outweighed by the negative impacts, including the loss of discipline associated with a regular payment stream, potential payment shock, a prolonged repayment schedule, and bank safety and 

soundness concerns. 
164 

RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO 

FROM DANIEL K. TARULLO 

Q.l. According to a recent New York Times article, about $870 billion, or roughly half of the industry’s $1.8 trillion of commercial 

real estate loans, now sit on the balance sheet of small and medium sized banks. To what extent has TALF encouraged capital to 

enter the commercial real estate market and what other step 

should regulators be taking to address this problem? 

Q.2. How will FASB’s new rules on off-balance sheet accounting 

impact financial institution’s ability to lend and how do you intend 

to implement the changes? 

A.l.–A.2. At the end of the second quarter of 2009, approximately 

$3.5 trillion of outstanding debt was associated with commercial 

real estate (CRE), including loans for multifamily housing developments. Of this amount, $1.7 trillion was held on the books of banks 

and thrifts, and an additional $900 billion represented collateral for 

commercial mortgage-backed securities (CMBS), with other investors holding the remaining balance of $900 billion. 

Before the crisis, securitization markets were an important conduit of credit to the household and business sectors. Securitization 

markets (other than those for mortgages guaranteed by the government) closed in mid-2008, and the TALF was developed to promote 

renewed issuance. Under the TALF, eligible investors may borrow 

to finance purchases of the AAA-rated tranches of various classes 

of asset-backed securities (ABS). The program originally focused on 

credit for households and small businesses, including auto loans, 

credit card loans, student loans, and loans guaranteed by the Small 

Business Administration. Investors may also use the TALF to purchase both existing and newly issued CMBS, which were included 

to help mitigate the refinancing problem in that sector. 

The TALF has been successful in helping restart securitization 

markets. Issuance has resumed and rate spreads for asset-backed 

securities have declined substantially. The TALF program has 

helped finance 2.5 million auto loans, 750,000 student loans, more 

than 100 million credit card accounts, 480,000 loans to small businesses, and 100,000 loans to larger businesses. Included among 

those business loans are 4,700 loans to auto dealers to help finance 

their inventories. Perhaps even more encouraging, a substantial 

fraction of ABS is now being purchased by investors that do not 

seek TALF financing, and ABS-issuers have begun to bring nonTALF-eligible deals to market. 

The TALF program provided financing to investors in the first 

new CMBS deal, totaling $400 million, since June 2008 on November 16. Significant investor demand drove down the spread on the 

AAA-rated TALF-eligible portion, with demand for the non-TALF 

eligible AA and A-rated tranches also higher than anticipated. The 

strong demand from cash investors and resulting low yield discouraged some TALF investors, resulting in the request for only $72.2 

million in TALF loans for the purchase of $85.0 million of the 

$323.4 million AAA-rated TALF-eligible portion of the deal. However, without the availability of TALF financing, it is unlikely that 

the deal would have come to market. Since then, we have seen another CMBS deal come to market, totaling $460 million, which did 
165 

not apply for TALF support. There are reports of a third deal, 

which would also not apply for TALF financing, totaling $600 million, due to be priced in December. We believe that the demonstration of investor demand for the DDR deal has encourage other 

lenders to bring similar conservatively underwritten single-borrower deals to market irrespective of the availability of TALF financing. Both non-TALF deals reportedly declined TALF financing 

in order to structure the securities with terms that are longer than 

the TALF loans. 

The Federal Reserve continues to inject liquidity into the commercial real estate market through the TALF program, and is 

working with market participants to increase transparency and investor protections in this market. We have issued guidance to 

banks to encourage modifications of maturing CRE loans on properties with sufficient rental income to continue to service the debt 

payments, but due to the continuing credit crunch are unable to obtain refinancing. And we continue to support broad economic 

growth that would improve the fundamentals of commercial real 

estate. 

As part of the lessons learned process, the President’s Working 

Group on Financial Markets and the Securities and Exchange 

Commission encouraged the FASB to re-assess its accounting 

standards for off-balance sheet vehicles. In response, and following 

a period of public comment on the proposal, FASB recently modified FAS 166 and 167. 

Under these modifications, an enterprise (e.g., company, individual, or group of bond holders) is required to consolidate certain 

special purpose entities (SPEs) whenever it has a ‘‘controlling financial interest’’ in the SPE, that is, the enterprise has the power 

to direct the SPE’s most significant activities and the right to receive benefits from, or obligation to bear losses of, the SPE. The accounting standards also require disclosure of the enterprise’s involvement with such SPEs and any significant changes in risk exposure that result. 

Whether an enterprise will be required to consolidate an SPE 

will depend on the specific facts and circumstances of each transaction. Beginning in 2010, many banking organizations that sponsor securitizations will be required to consolidate the associated 

SPEs. Certain asset-backed commercial paper conduits, revolving 

securitizations structured as master trusts (such as credit card 

securitizations), mortgage loan securitizations not guaranteed by 

the U.S. Government or a U.S. Government-sponsored agency, and 

term loan securitizations (such as auto and student loan 

securitizations), are among the types of securitization SPEs that 

will likely require consolidation by their sponsoring banking organization. In almost all cases, the SPE consolidation requirements 

will not apply to investors in the asset-backed securities, because 

such investors generally do not have power to direct the SPE’s 

most significant activities. 
166 

1See The Institute of International Finance, Inc. (2009), Compensation in Financial Services: 

Industry Progress and the Agenda for Change (Washington: IIF, March). 2 Board of Governors of the Federal Reserve System (2009), ‘‘Federal Reserve Issues Proposed 

Guidance on Incentive Compensation,’’ press release, October 22, 2009. 

RESPONSES TO WRITTEN QUESTIONS OF SENATOR VITTER 

FROM DANIEL K. TARULLO 

Q.l. Mr. Tarullo, I am concerned about the Federal Reserve overstepping the authority Congress has granted. News reports about 

the Federal Reserve giving itself the authority to veto pay packages 

is beyond the pale. • Can you please submit for the record, where in the Federal Reserve Act the Fed [is] given the authority to regulate compensation agreements? 

• Why should the Federal Reserve be allowed to veto pay agreements that are approved by a company’s board of directors? 

• How involved has Chairman Bernanke been in drafting this illegal rulemaking? 

• Which Federal Reserve Governor has been pushing the Federal 

Reserve’s policy on this issue? 

A.l. The Federal Reserve’s proposed supervisory guidance and related supervisory initiatives regarding incentive compensation 

practices derive from our statutory mandate to protect the safety 

and soundness of the banking organizations we supervise. The proposed guidance was developed in consultation with all Board members and all Board members voted in favor of issuing the proposed 

guidance for public comment. 

Recent events have highlighted that improper compensation 

practices can contribute to safety and soundness problems at financial institutions and to financial instability. Compensation practices 

were not the sole cause of the crisis, but they certainly were a contributing cause—a fact recognized by 98 percent of the respondents 

to a 2009 survey conducted by the Institute of International Finance of banking organizations engaged in wholesale banking activities.1 The Federal Reserve and the other Federal banking agencies regularly issue supervisory guidance to identify practices that 

the agencies believe would ordinarily constitute an unsafe or unsound practice, or to identify risk management systems, controls, 

or other practices that the agencies believe would ordinarily assist 

banking organizations in ensuring that they operate in a safe and 

sound manner. 

The proposed supervisory guidance, which currently is out for 

public comment,2 is based on three key principles: (1) incentive 

compensation arrangements at a banking organization should not 

provide employees incentives to take risks that are beyond the organization’s ability to effectively identify and manage; (2) they 

should be compatible with effective controls and risk management; 

and (3) they should be supported by strong corporate governance, 

including active and effective oversight by the organization’s board 

of directors. Consistent with these principles, the Federal Reserve’s 

efforts are focused on ensuring that the way in which banking organizations structure their incentive compensation arrangements 

do not—intentionally or unintentionally encourage excessive risktaking, and that banking organization’s have the types of policies, 
167 

3See The Institute of International Finance, Inc. (2009), Compensation in Financial Services: 

Industry Progress and the Agenda for Change (Washington: IFF, March). 4See Senior Supervisors Group (2009), Risk Management Lessons from the Global Banking 

Crisis of 2008. 5See Financial Stability Board (2009), Principles for Sound Incentive Compensation Practices. 

procedures, internal controls, and corporate governance structures 

to promote and maintain sound incentive compensation arrangements. 

Importantly, the proposed guidance does not mandate that banking organizations follow any particular method for achieving appropriately risk-sensitive incentive compensation arrangements. In 

fact, the guidance expressly recognizes that the methods used to 

achieve risk-sensitive compensation arrangements likely will differ 

across and within firms, and that use of a single, formulaic approach is unlikely to consistently promote safety and soundness. 

Q.2. Is it the Federal Reserve’s official position that executive compensation is a cause of systemic risk? 

• If so, can you please provide this Committee with documentation to support this position? 

A.2. Pay practices for risk-taking employees at many levels in 

banking organizations, not just top executive pay practices, were 

one among many contributors to the crisis. The role of compensation practices in the crisis has been widely recognized by both industry and supervisors, both here and overseas. For example, in 

their responses to a survey conducted by the Institute of International Finance, a global association of major financial institutions, 36 of 37 large banking organizations engaged in wholesale 

activities agreed that compensation practices were a factor underlying the crisis.3 The Senior Supervisors Group, which is composed 

of senior financial supervisors from seven major industrialized 

countries (the United States, Canada, France, Germany, Japan, 

Switzerland, and the United Kingdom), also reported that many 

firms and their supervisors had determined that failures of incentives and controls throughout the industry, including those related 

to compensation, contributed to systemic vulnerability during the 

crisis.4 Moreover, the Financial Stability Board, a group composed 

of senior representatives of national financial authorities, international financial institutions, standard setting bodies, and committees of central bank experts, has identified compensation practices as a factor contributing to the crisis.5

Q.3. What comments has the Federal Reserve received on this proposal from the banks it regulates? 

A.3. The comment period closed on November 27, 2009. The Board 

has received 29 comments on the proposed guidance, four of which 

were submitted on behalf of individual banking organizations, five 

of which were submitted on behalf of groups representing multiple 

banking organizations, and two of which were submitted on behalf 

of groups representing both banking and nonbanking organizations. 

Public comments on the proposal are made available on the Board’s 

website at http://www.federafreserve.gov/generalinfo/foia/index. 

cfin?doclid=OPpercent2D1374&doclver=l. 

Q.4. Mr. Tarullo, regarding the specifics of the proposal: 
168 

• Would the Federal Reserve require companies to ‘‘clawback’’ 

money that’s already been paid to employees? 

• Is there a threshold a bank must meet to qualify for a review 

of executive compensation arrangements? 

A.4. The proposed guidance provides that incentive compensation 

arrangements should not encourage excessive risk-taking, and describes several methods that are currently used by banking organizations to make compensation more sensitive to risk. These methods can be broadly described as risk adjustment of awards, deferral 

of payment, longer performance periods, and reduced sensitivity to 

short-term risk. As noted in the proposed guidance, the deferral of 

payment method is sometimes referred to in the industry as a 

‘‘clawback.’’ The term ‘‘clawback’’ also may refer specifically to an 

arrangement under which an employee must return incentive compensation payments previously received by the employee (and not 

just deferred) if certain risk outcomes occur. 

Importantly, the proposed guidance does not require a banking 

organization to use any particular method, including those described in the guidance, to ensure that its incentive compensation 

arrangements do not encourage employees to take excessive risks. 

In fact, the proposed guidance expressly recognizes that the methods discussed in the guidance have their own advantages and disadvantages, and that banking organizations will need flexibility in 

determining how best to achieve balanced incentive compensation 

arrangements in light of the particular activities, structure, and 

other characteristics of the organization. 

The proposed supervisory guidance would apply to all banking 

organizations that are supervised by the Federal Reserve. These organizations are primarily responsible for ensuring that their incentive compensation arrangements do not encourage excessive risktaking or pose a threat to the safety and soundness of the organization. To help promote and monitor the development of safe and 

sound incentive compensation arrangements, the Federal Reserve 

also has announced two, separate supervisory initiatives. These 

two separate programs are designed to reflect the differences 

among the universe of banking organizations supervised by the 

Federal Reserve. The first initiative involves a special, horizontal 

review of incentive compensation practices at large, complex banking organizations (LCBOs). LCBOs warrant special supervisory attention because they are significant users of incentive compensation arrangements and because flawed practices at these institutions are more likely to have adverse effects on the broader financial system. 

A separate program will apply to the thousands of other organizations supervised by the Federal Reserve, including community 

and regional banking organizations. Supervisory staff will review 

incentive compensation arrangements at these organizations as 

part of the regular risk-focused examination process. These reviews, as well as our supervisory expectations for these organizations, will be tailored to reflect the more limited scope and complexity of these organizations’ activities—a fact also recognized in 

various aspects of our guidance. 
169 

RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO 

FROM DEBORAH K. MATZ 

Q.1. According to a recent New York Times article, about $870 bil- lion, or roughly half of the industry’s $1.8 trillion of commercial 

real estate loans, now sit on the balance sheet of small and medium sized banks. To what extent has TALF encouraged capital to 

enter the commercial real estate market and what other step 

should regulators be taking to address this problem? 

A.2. For the most part, credit unions have not participated in 

TALF. As cooperatives, many credit unions maintain a whole membership philosophy and seek to retain all of their members’ financial business in-house. While federally insured credit unions hold 

less than 1.5 percent of all commercial real estate loans, the credit 

union industry’s involvement in commercial lending has increased. 

Loans to members for business purposes have more than quintupled from December 2002 to June 2009, rising from $6.7 billion 

to $33.7 billion. Of the $33.7 billion member business loan portfolio, 76 percent are secured by real estate. 

The credit union industry has continued to grant member business loans even when most other financial service providers are 

contracting. For the first half of 2009, member business loans experienced 11.9 percent growth. 

NCUA is encouraging the flow of credit in these difficult economic times. Below are some examples of recent actions taken to 

promote balancing safety and soundness issues with the credit 

unions’ desire to meet their members’ financial needs. This month, 

NCUA hosted a webcast for credit unions and examiners entitled 

‘‘Member Business Lending: Regulators’ Perspective,’’ which provided guidance, best practices, and insight into the underwriting 

and examination of member business lending. This webcast provided a balanced view of the needs of the industry with safety and 

soundness considerations. 

Additionally, NCUA recently released a joint policy statement 

with the Federal Financial Institutions Examination Council 

(FFIEC) supporting prudent commercial real estate (CRE) loan 

workouts. This statement provides guidance for examiners and financial institutions that are working with CRE borrowers who are 

experiencing diminished operating cash-flows, depreciated collateral values, or prolonged delays in selling or renting commercial 

properties. This guidance discusses another component of the current lending environment that the financial industry is currently 

facing. 

In order to further encourage credit union involvement in commercial lending, Congress could consider raising or removing the 

current statutory limitation on member business lending. The Federal Credit Union Act currently limits federally insured credit 

unions to 1.75 times the actual net worth of the credit union or 

1.75 times the minimum net worth required for the credit union to 

be considered well capitalized. Raising or eliminating this limitation on member business loans will increase credit unions’ ability 

to generate and hold more loans to small businesses served by 

those credit unions, while providing NCUA with the ability and obligation to set standards and benchmarks for this activity based on 

the needs of the industry. NCUA understands an increase or elimi-
170 

nation of this limitation without prudent regulatory oversight could 

pose significant risk to individual credit unions, and is prepared to 

provide the necessary oversight. 

NCUA is also aware of the importance of increasing lending in 

the commercial real estate market in order to stimulate the economy, while ensuring the safety and soundness of the institutions 

the NCUA regulates and insures. There is a fine balance between 

these two objectives that the NCUA is encouraging the credit union 

industry to find. In fact, a Letter to Credit Unions that promotes 

best practices of member business lending is currently in process. 

NCUA will continue to issue guidance to examiners and the credit 

union industry to address issues related to the current financial 

and economical environment. 

Q.2. How will FASB’s new rules on off-balance sheet accounting 

impact financial institution’s ability to lend and how do you intend 

to implement the changes? 

A.2. The FASB’s new rules will make it more difficult for credit 

unions to sell loans or portions of loans and gain the benefit of removing those assets from their books through sales treatment. For 

a small number of credit unions who engage in securitization transactions, the new rules will make it difficult to avoid consolidation 

accounting with the securitization trust. In either case, the net 

worth ratio will be diluted by the ‘‘transferred’’ financial assets that 

must remain on the credit unions’ books even though ‘‘sold’’. In the 

former case, NCUA anticipates that credit unions will restructure 

legal transfer agreements to conform loans sales and partial loan 

sales to the ‘‘participating interest’’ rules of the new standard and 

proceed with business as usual. In the latter case, the small number of credit unions that engage in securitization structures will 

most likely cease and desist from this activity. 

The larger and more onerous impact of the new accounting rules 

will fall on the NCUA Board and the Funds it oversees. The NCUA 

Board oversees the National Credit Union Share Insurance Fund 

(‘‘NCUSIF’’), the Corporate Credit Union Stabilization Fund (‘‘Stabilization Fund’’), the Central Liquidity Facility (‘‘CLF’’), the NCUA 

Operating Fund, and the Community Development Revolving Loan 

Fund. NCUA prepares its financial statement under U.S. generally 

accepted accounting principles (‘‘GAAP’’) for commercial enterprises. 

As the NCUA Board acts under its statutory authorities to 

‘‘workout’’ troubled credit unions with the least cost to the NCUSIF 

and the Stabilization Fund, the new accounting rules will most 

likely require NCUSIF to consolidate with the Stabilization Fund 

as well as conserved, troubled credit unions under the NCUA 

Board oversight. Financial statement consolidation of the NCUSIF, 

the Stabilization Fund, and troubled, conserved credit unions solely 

due to the NCUA Board exercising its statutory powers as it acts 

within its mission under moral obligation to protect credit union 

and taxpayer resources is not a plausible outcome of applying accounting rules. The new rules assume a ‘‘profit making’’ incentive 

behind NCUA’s actions when, in fact, its actions are statutory in 

nature—supervision and Federal deposit insurance. 
171 

The primary readers of the NCUSIF financial statements—credit 

union members, the public, and the U.S. Treasury Department— 

are not better served by the consolidated presentation of governmental with non-governmental entities. A scope exception for government entities from consolidating with the entities it supervises 

and insures would be the optimal outcome. The FASB has not been 

receptive to such a scope exception primarily because it would not 

have wide applicability and there is an existing scope exception 

within the standard for non-profit entities. 

RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO 

FROM TIMOTHY WARD 

Q.1. According to a recent New York Times article, about $870 billion, or roughly half of the industry’s $1.8 trillion of commercial 

real estate loans, now sit on the balance sheet of small- and medium-sized banks. To what extent has TALF encouraged capital to 

enter the commercial real estate market and what other step 

should regulators be taking to address this problem? 

A.1. The Term Asset-Backed Securities Loan Facility (TALF) program was primarily created to help restore liquidity in the assetbacked securities markets. Since the Federal Reserve Board (the 

FRB) announced an expansion of the TALF to include commercial 

mortgage-backed securities (CMBS), the Federal Reserve Bank of 

New York (FRBNY) has received loan requests totaling $6.5 billion 

to help fund the purchase of legacy CMBS (those created prior to 

January 1, 2009). 

Improvements in CMBS market liquidity and confidence have occurred since the severe dislocations in these markets during late 

summer/early fall of 2008. Most notably, the yield spreads between 

CMBS and 10-year Treasury securities have narrowed significantly 

from over 10 percent in late summer/early fall 2008 to about 4.5 

percent in November 2009. Though still wider than typical spreads 

of about 1.5 percent, the narrowing of spreads is evidence of normalization of the CMBS markets. And it is likely the TALF program contributed to these improvements. 

It is important to note that only a small percentage of commercial real estate loans are in CMBS. According to estimates from the 

Commercial Mortgage Securities Association, only about 25 percent 

of total commercial real estate loans are held in CMBS. This may 

point to the need to expand TALF, or similar programs, beyond the 

CMBS markets to help address rising problems in commercial real 

estate. And this is especially true for small- and medium-sized 

banks and thrifts. 

Q.2. How will FASB’s new rules on off-balance sheet accounting 

impact financial institution’s ability to lend and how do you intend 

to implement the changes? 

A.2. As a result of the FASB accounting changes, generally effective the beginning of 2010 for most institutions, many 

securitizations previously off-balance sheet will come on-balance 

sheet and many new securitizations will stay on-balance sheet. 

Consequently, higher regulatory capital requirements will result 

from the larger balance sheets and some institutions may need to 
172 

raise additional capital or shrink their balance sheet size, which 

could result in a downward pressure on lending activity and increase the costs of borrowing. 

The Federal banking agencies require that regulatory reports 

comply with Generally Accepted Accounting Principles (GAAP). By 

law, reports filed with the Federal banking agencies must be uniform and consistent with and no less stringent than GAAP (as required by Section 37 of the FDI Act). Consequently, securitization 

accounting must be reported by financial institutions in accordance 

with GAAP. GAAP serves as the starting point for regulatory capital treatment. 

Due to these GAAP accounting changes, an Interagency Notice of 

Proposed Rulemaking (NPR) for the regulatory capital treatment of 

securitizations was issued. The comment period for the NPR closed 

on October 15, 2009. The NPR proposed to follow the new GAAP 

treatment for regulatory capital purposes as, unless determined 

otherwise based upon information provided through the comment 

process, the agencies believe the new GAAP more appropriately reflects the securitization risks to which financial institutions are exposed. The comments are currently being evaluated by the banking 

agencies with the expectation of issuing a final rule before the regulatory reporting of these accounting changes. 

Q.3. What is the impact of the proposed action by the Office of the 

Comptroller of the Currency and the Office of Thrift Supervision to 

end ‘‘no payment’’ deferred interest financing promotions on consumers and businesses? I understand the impact to be very large 

and I would appreciate the agencies working to clarify that ‘‘no 

payment’’ deferred interest financing promotions can be used in the 

future albeit perhaps with revised disclosures and marketing. 

A.3. Over the past year, OTS and OCC have worked closely to develop their respective policy statements, which are substantially 

identical. On September 24, 2009, OTS issued CEO Letter 321— 

‘‘No Interest, No Payment’’ Credit Card Programs to remind savings associations of certain requirements contained in the 2003 

interagency ‘‘Account Management and Loss Allowance Guidance 

for Credit Card Lending.’’ That guidance articulated sound account 

management, risk management, and loss allowance practices for all 

institutions engaged in credit card lending. 

CEO Letter 321 reminds savings associations of OTS’s longstanding position that minimum monthly payments are a key tenet 

of safe and sound retail lending and should be required on credit 

card accounts. It states that regular monthly payments add structure and discipline to the lending arrangement, provide regular 

and ongoing contact with the borrower, and allow the borrower to 

demonstrate and the bank to assess continued willingness and ability to repay the obligation over time. Conversely, the absence of a 

regular payment stream may result in protracted repayment and 

mask true portfolio performance and quality. Further, in accordance with the OTS Examination Handbook, it indicates that the 

minimum monthly payment should cover at least a 1-percent principal reduction plus all assessed monthly interest and finance 

charges. CEO Letter 321 neither prohibits nor discourages the 

practice of ‘‘no interest’’ credit card promotions. 
173 

Finally, the CEO Letter states that savings associations will be 

given a reasonable time to implement any changes to their existing 

programs as a result of the policy clarification. All savings associations are expected to be in full compliance for all new credit card 

transactions no later than February 22, 2010. 

OTS has no precise data on the expected impact of the OTS and 

OCC ending the no payment programs offered by banks and savings associations. Because of the increased delinquencies associated 

with certain customers of no-pay accounts, we expect a decline in 

loan delinquencies and chargeoffs. While there may be a curtailment in the number of purchases that these programs facilitate, 

OTS believes that the primary affect will be for borrowers who cannot afford the purchases. 

In arriving at the decision to issue a letter on these programs, 

OTS considered, among other things, that recent examinations of 

OTS-supervised savings associations that offer ‘‘no interest, no payment’’ credit card programs revealed increasing past due and losses 

related to these accounts. OTS examination staff noted that: 

No payment promotions present substantially higher credit risk (unexpected loss) to banks than regular revolving accounts. This is not necessarily because the accounts/customers themselves are riskier; but because 

the structure of the promotion results in an inability to adequately monitor 

and assess risk. These promotions also present problems for customers who 

are less adept at managing their finances. The best way to address these 

problems is to require some level of minimum monthly payments. 

No payment promotions are most prevalent on big ticket purchases such as furniture, or big screen televisions. These types of 

purchases often result in balances of $5,000 or more. Many view 

promotional programs that offer no payments until next year as 

being designed to entice customers into making a large purchase 

that they may not otherwise have considered or thought they 

couldn’t afford. It allows customers to acquire these items without 

worrying about paying for them for a long period of time. For those 

customers who are not as adept at managing their finances, it may 

be very difficult to make a $5,000 payment at the end of the promotion—at which time they will incur high financing costs, in some 

cases (back-billing) all of the costs they thought they were avoiding. 
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RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO 

FROM JOSEPH A. SMITH 

Q.1. According to a recent New York Times article, about $870 bil- lion, or roughly half of the industry’s $1.8 trillion of commercial 

real estate loans, now sit on the balance sheet of small and medium sized banks. To what extent has TALF encouraged capital to 

enter the commercial real estate market and what other step 

should regulators be taking to address this problem? 

A.1. Did not respond by printing deadline. 

Q.2. How will FASB’s new rules on off-balance sheet accounting 

impact financial institution’s ability to lend and how do you intend 

to implement the changes? 

A.2. Did not respond by printing deadline. 

RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO 

FROM THOMAS J. CANDON 

Q.1. According to a recent New York Times article, about $870 billion, or roughly half of the industry’s $1.8 trillion of commercial 

real estate loans, now sit on the balance sheet of small and medium sized banks. To what extent has TALF encouraged capital to 

enter the commercial real estate market and what other step 

should regulators be taking to address this problem? 

A.1. The financial institutions supervised by NASCUS members— 

state-chartered credit unions—do not have access to TALF. 

Q.2. How will FASB’s new rules on off-balance sheet accounting 

impact financial institution’s ability to lend and how do you intend 

to implement the changes? 

A.2. State-chartered credit unions have not made substantive use 

of the new FASB provisions related to off-balance sheet accounting 

and accordingly, it is not anticipated that these changes by FASB 

will have a material impact on the ability of credit unions to lend 

to their members. Credit unions will be minimally impacted, if at 

all. The two areas of primary structural constraint regarding credit 

union lending continue to be field of membership restrictions and 

the limitations imposed by Federal restrictions on member business lending. FASB’s new rules regarding off-balance sheet accounting are likely to have a more substantial impact on large commercial banks which may have utilized off-balance sheet structures 

to mitigate on-balance sheet risk.