Ben S Bernanke: Semiannual Monetary Policy Report to the Congress
Testimony by Mr Ben S Bernanke, Chairman of the Board of Governors of the Federal
Reserve System, before the Committee on Banking, Housing, and Urban Affairs, US Senate,
Washington DC, 21 July 2010.
* * *
Chairman Dodd, Senator Shelby, and members of the Committee, I am pleased to present
Monetary Policy Report to the
the Federal Reserve's semiannual Congress.
Economic and financial developments
The economic expansion that began in the middle of last year is proceeding at a moderate
pace, supported by stimulative monetary and fiscal policies. Although fiscal policy and
inventory restocking will likely be providing less impetus to the recovery than they have in
recent quarters, rising demand from households and businesses should help sustain growth.
In particular, real consumer spending appears to have expanded at about a 2-1/2 percent
annual rate in the first half of this year, with purchases of durable goods increasing especially
rapidly. However, the housing market remains weak, with the overhang of vacant or
foreclosed houses weighing on home prices and construction.
An important drag on household spending is the slow recovery in the labor market and the
attendant uncertainty about job prospects. After two years of job losses, private payrolls
expanded at an average of about 100,000 per month during the first half of this year, a pace
insufficient to reduce the unemployment rate materially. In all likelihood, a significant amount
of time will be required to restore the nearly 8-1/2 million jobs that were lost over 2008 and
2009. Moreover, nearly half of the unemployed have been out of work for longer than six months.
Long-term unemployment not only imposes exceptional near-term hardships on workers and
their families, it also erodes skills and may have long-lasting effects on workers' employment
and earnings prospects.
In the business sector, investment in equipment and software appears to have increased
rapidly in the first half of the year, in part reflecting capital outlays that had been deferred
during the downturn and the need of many businesses to replace aging equipment. In
contrast, spending on nonresidential structures - weighed down by high vacancy rates and
tight credit - has continued to contract, though some indicators suggest that the rate of
decline may be slowing. Both U.S. exports and U.S. imports have been expanding, reflecting
growth in the global economy and the recovery of world trade. Stronger exports have in turn
helped foster growth in the U.S. manufacturing sector.
Inflation has remained low. The price index for personal consumption expenditures appears
to have risen at an annual rate of less than 1 percent in the first half of the year. Although
overall inflation has fluctuated, partly reflecting changes in energy prices, by a number of
measures underlying inflation has trended down over the past two years. The slack in labor
and product markets has damped wage and price pressures, and rapid increases in
productivity have further reduced producers' unit labor costs.
My colleagues on the Federal Open Market Committee (FOMC) and I expect continued
moderate growth, a gradual decline in the unemployment rate, and subdued inflation over the
next several years. In conjunction with the June FOMC meeting, Board members and Reserve
Bank presidents prepared forecasts of economic growth, unemployment, and inflation for the
years 2010 through 2012 and over the longer run. The forecasts are qualitatively similar to
those we released in February and May, although progress in reducing unemployment is
now expected to be somewhat slower than we previously projected, and near-term inflation
now looks likely to be a little lower. Most FOMC participants expect real GDP growth of 3 to
3-1/2 percent in 2010, and roughly 3-1/2 to 4-1/2 percent in 2011 and 2012. The
unemployment rate is expected to decline to between 7 and 7-1/2 percent by the end of 2012.
Most participants viewed uncertainty about the outlook for growth and unemployment as
greater than normal, and the majority saw the risks to growth as weighted to the downside.
Most participants projected that inflation will average only about 1 percent in 2010 and that it
will remain low during 2011 and 2012, with the risks to the inflation outlook roughly balanced.
One factor underlying the Committee's somewhat weaker outlook is that financial conditions
- though much improved since the depth of the financial crisis - have become less
supportive of economic growth in recent months. Notably, concerns about the ability of
Greece and a number of other euro-area countries to manage their sizable budget deficits
and high levels of public debt spurred a broad-based withdrawal from risk-taking in global
financial markets in the spring, resulting in lower stock prices and wider risk spreads in the
United States. In response to these fiscal pressures, European leaders put in place a number
of strong measures, including an assistance package for Greece and €500 billion of funding
to backstop the near-term financing needs of euro-area countries. To help ease strains in
U.S. dollar funding markets, the Federal Reserve reestablished temporary dollar liquidity
swap lines with the ECB and several other major central banks. To date, drawings under the
swap lines have been limited, but we believe that the existence of these lines has increased
confidence in dollar funding markets, helping to maintain credit availability in our own
financial system.
Like financial conditions generally, the state of the U.S. banking system has also improved
significantly since the worst of the crisis. Loss rates on most types of loans seem to be
peaking, and, in the aggregate, bank capital ratios have risen to new highs. However, many
banks continue to have a large volume of troubled loans on their books, and bank lending
standards remain tight. With credit demand weak and with banks writing down problem
credits, bank loans outstanding have continued to contract. Small businesses, which depend
importantly on bank credit, have been particularly hard hit. At the Federal Reserve, we have
been working to facilitate the flow of funds to creditworthy small businesses. Along with the
other supervisory agencies, we issued guidance to banks and examiners emphasizing that
lenders should do all they can to meet the needs of creditworthy borrowers, including small
businesses.1 We also have conducted extensive training programs for our bank examiners,
with the message that lending to viable small businesses is good for the safety and
soundness of our banking system as well as for our economy. We continue to seek feedback
from both banks and potential borrowers about credit conditions. For example, over the past
six months we have convened more than 40 meetings around the country of lenders, small
business representatives, bank examiners, government officials, and other stakeholders to
exchange ideas about the challenges faced by small businesses, particularly in obtaining
credit. A capstone conference on addressing the credit needs of small businesses was held
at the Board of Governors in Washington last week.2 This testimony includes an addendum
that summarizes the findings of this effort and possible next steps.
Federal Reserve policy
The Federal Reserve's response to the financial crisis and the recession has involved
several components. First, in response to the periods of intense illiquidity and dysfunction in
financial markets that characterized the crisis, the Federal Reserve undertook a range of
measures and set up emergency programs designed to provide liquidity to financial
institutions and markets in the form of fully secured, mostly short-term loans. Over time,
these programs helped to stem the panic and to restore normal functioning in a number of
key financial markets, supporting the flow of credit to the economy. As financial markets
stabilized, the Federal Reserve shut down most of these programs during the first half of this
year and took steps to normalize the terms on which it lends to depository institutions. The
only such programs currently open to provide new liquidity are the recently reestablished
dollar liquidity swap lines with major central banks that I noted earlier. Importantly, our
broadbased programs achieved their intended purposes with no loss to taxpayers. All of the loans
extended through the multiborrower facilities that have come due have been repaid in full,
with interest. In addition, the Board does not expect the Federal Reserve to incur a net loss
on any of the secured loans provided during the crisis to help prevent the disorderly failure of
systemically significant financial institutions.
A second major component of the Federal Reserve's response to the financial crisis and
recession has involved both standard and less conventional forms of monetary policy. Over
the course of the crisis, the FOMC aggressively reduced its target for the federal funds rate
to a range of 0 to 1/4 percent, which has been maintained since the end of 2008. And, as
indicated in the statement released after the June meeting, the FOMC continues to anticipate
that economic conditions - including low rates of resource utilization, subdued inflation
trends, and stable inflation expectations - are likely to warrant exceptionally low levels of the
federal funds rate for an extended period.3
In addition to the very low federal funds rate, the FOMC has provided monetary policy
stimulus through large-scale purchases of longer-term Treasury debt, federal agency debt,
and agency mortgage-backed securities (MBS). A range of evidence suggests that these
purchases helped improve conditions in mortgage markets and other private credit markets
and put downward pressure on longer-term private borrowing rates and spreads.
Compared with the period just before the financial crisis, the System's portfolio of domestic
securities has increased from about $800 billion to $2 trillion and has shifted from consisting
of 100 percent Treasury securities to having almost two-thirds of its investments in
agencyrelated securities. In addition, the average maturity of the Treasury portfolio nearly doubled,
from three and one-half years to almost seven years. The FOMC plans to return the
System's portfolio to a more normal size and composition over the longer term, and the
Committee has been discussing alternative approaches to accomplish that objective.
One approach is for the Committee to adjust its reinvestment policy - that is, its policy for
handling repayments of principal on the securities - to gradually normalize the portfolio over
time. Currently, repayments of principal from agency debt and MBS are not being reinvested,
allowing the holdings of those securities to run off as the repayments are received. By
contrast, the proceeds from maturing Treasury securities are being reinvested in new issues
of Treasury securities with similar maturities. At some point, the Committee may want to shift
its reinvestment of the proceeds from maturing Treasury securities to shorter-term issues, so
as to gradually reduce the average maturity of our Treasury holdings toward pre-crisis levels,
while leaving the aggregate value of those holdings unchanged. At this juncture, however, no
decision to change reinvestment policy has been made.
A second way to normalize the size and composition of the Federal Reserve's securities
portfolio would be to sell some holdings of agency debt and MBS. Selling agency securities,
rather than simply letting them run off, would shrink the portfolio and return it to a
composition of all Treasury securities more quickly. FOMC participants broadly agree that
sales of agency-related securities should eventually be used as part of the strategy to
normalize the portfolio. Such sales will be implemented in accordance with a framework
communicated well in advance and will be conducted at a gradual pace. Because changes in
the size and composition of the portfolio could affect financial conditions, however, any
decisions regarding the commencement or pace of asset sales will be made in light of the
Committee's evaluation of the outlook for employment and inflation.
As I noted earlier, the FOMC continues to anticipate that economic conditions are likely to
warrant exceptionally low levels of the federal funds rate for an extended period. At some
point, however, the Committee will need to begin to remove monetary policy accommodation
to prevent the buildup of inflationary pressures. When that time comes, the Federal Reserve
will act to increase short-term interest rates by raising the interest rate it pays on reserve
balances that depository institutions hold at Federal Reserve Banks. To tighten the linkage
between the interest rate paid on reserves and other short-term market interest rates, the
Federal Reserve may also drain reserves from the banking system. Two tools for draining
reserves from the system are being developed and tested and will be ready when needed.
First, the Federal Reserve is putting in place the capacity to conduct large reverse
repurchase agreements with an expanded set of counterparties. Second, the Federal
Reserve has tested a term deposit facility, under which instruments similar to the certificates
of deposit that banks offer their customers will be auctioned to depository institutions.
Of course, even as the Federal Reserve continues prudent planning for the ultimate
withdrawal of extraordinary monetary policy accommodation, we also recognize that the
economic outlook remains unusually uncertain. We will continue to carefully assess ongoing
financial and economic developments, and we remain prepared to take further policy actions
as needed to foster a return to full utilization of our nation's productive potential in a context
of price stability.
Financial reform legislation
Last week, the Congress passed landmark legislation to reform the financial system and
financial regulation, and the President signed the bill into law this morning. That legislation
represents significant progress toward reducing the likelihood of future financial crises and
strengthening the capacity of financial regulators to respond to risks that may emerge.
Importantly, the legislation encourages an approach to supervision designed to foster the
stability of the financial system as a whole as well as the safety and soundness of individual
institutions. Within the Federal Reserve, we have already taken steps to strengthen our
analysis and supervision of the financial system and systemically important financial firms in
ways consistent with the new legislation. In particular, making full use of the Federal
Reserve's broad expertise in economics, financial markets, payment systems, and bank
supervision, we have significantly changed our supervisory framework to improve our
consolidated supervision of large, complex bank holding companies, and we are enhancing
the tools we use to monitor the financial sector and to identify potential systemic risks. In
addition, the briefings prepared for meetings of the FOMC are now providing increased
coverage and analysis of potential risks to the financial system, thus supporting the Federal
Reserve's ability to make effective monetary policy and to enhance financial stability.
Much work remains to be done, both to implement through regulation the extensive
provisions of the new legislation and to develop the macroprudential approach called for by
the Congress. However, I believe that the legislation, together with stronger regulatory
standards for bank capital and liquidity now being developed, will place our financial system
on a sounder foundation and minimize the risk of a repetition of the devastating events of the
past three years.
Thank you. I would be pleased to respond to your questions.
Addendum:
Addressing the financing needs of small businesses
Summary of key themes for the Federal Reserve System's small business meeting series
Introduction
The Federal Reserve System's Community Affairs Offices hosted more than 40 meetings in
2010 as part of an initiative titled "Addressing the Financing Needs of Small Businesses."4
The goal was to gather information and perspectives to help the Federal Reserve and other
stakeholders address the immediate and intermediate credit needs of small businesses.
Some of the meetings took the form of small focus groups or listening sessions. Other
meetings were on a larger scale, with more formal agendas focusing on a particular aspect of
small business financing, such as minority entrepreneurship, the role of Community
Development Financial Institutions (CDFIs), or federal guarantee loan programs. Several
meetings focused on a specific industry, such as auto suppliers.
Whether small or large, all of the meetings brought together small business owners, small
business trade groups, financial institutions and other private lenders, bank supervision
officials, CDFIs, and other small business support service providers to discuss ways to
improve credit flow to viable small businesses. Through this initiative, the Federal Reserve
sought to deepen its understanding of the dynamics of the supply of and demand for small
business credit, to identify specific credit gaps, and to learn of promising practices and
suggestions for improvement.
This summary aims to capture the key issues that emerged from the meetings and offer
examples of how those issues were reflected in different parts of the country and in different
industries. It is not intended to be a comprehensive compilation of all the ideas and views
that were expressed. We have grouped the comments under the categories of credit supply,
credit demand, and credit gaps. In addition, we have included key recommendations for
potential next steps that were identified by participants at the July 12 capstone event at the
Board of Governors as well as throughout the System's series of meetings.
Factors impacting the supply of small business credit
Small businesses and banks generally reported that lending contracted significantly during
the recession for a variety of reasons. These comments are consistent with data indicating
that outstanding loans to small businesses dropped from more than $710 billion in the
second quarter of 2008 to less than $670 billion in the first quarter of 2010.5 In addition,
some banks noted that some of the contraction in lending is related to broader concerns
about capital adequacy. Comments related to the supply of credit to small businesses fell
into four broad categories: 1) tighter bank underwriting standards; 2) resource constraints on
lending; 3) impact of regulatory guidance; and 4) utilization of alternative funding sources.
- At most meetings, both small businesses and banks
Underwriting standards
acknowledged that underwriting standards had tightened. Some small businesses reported
that underwriting changes made access to credit more difficult, but not impossible, while
others found the changes to be a significant hurdle to obtaining credit. Many banks
acknowledged that lending standards had become more flexible prior to the economic
downturn and that they since have returned to more traditional underwriting practices.
Recurring issues related to underwriting standards included the following:

Additional collateral requirements - For existing loans, small businesses reported
that routine collateral re-evaluations of assets that directly or indirectly secure loans
- including personal residences, commercial property, and equipment - often result
in additional collateral requirements because of a significant drop in asset values. In
addition, in some markets, banks noted they were no longer readily taking real
estate as collateral, especially if there was another outstanding lien against the
property. Many banks have also reduced their loan-to-value (LTV) thresholds,
increasing the amount of equity businesses need for new and refinance loans.
- At a meeting in Cincinnati, small business owners said they were required to
make cash payments when reassessments of LTV ratios resulted in insufficient
collateral. If the payment was not made, the loan could be subject to default.
For new loans, small businesses cited heavy collateral requirements, including
personal guarantees, which made them reluctant to secure the loan.
- In Detroit, auto suppliers emphasized their concern about the values that
lenders are placing on their collateral, particularly equipment. An official with an
auto supplier trade group confirmed that many of his group's members have
reported issues relating to banks' current lower valuation of assets that back
existing loans or that are being assessed for new loans.

Greater focus on cash flow - Some banks acknowledged that prior to the
economic crisis, credit scores or collateral values, often inflated, were sometimes
more important than cash flow in underwriting a small business loan. Banks and
small businesses both concurred that strong cash flow is now one of the chief
underwriting criteria.
- At the Baltimore meeting, several bankers said that they understand the
frustration of small businesses that may be experiencing reduced cash flow
during the recession but that had a solid track record before the downturn.
They noted, however, that generally they cannot extend credit if there is no
recent history of positive cash flow. According to one banker, even if a
business has strong collateral, banks do not want to be in the business of
taking collateral to recoup loan principal.
- In Dayton, a small business owner stated: "If you have the money you need
[i.e., good cash flow and collateral], then they'll loan to you."

Higher personal credit thresholds, including credit score - Small businesses
commented that, in response to concerns about declining collateral values and cash
flow, the recent trend has been to require more personal resources and guarantees.
For many larger banks, automated underwriting driven primarily by credit scores is
the only way to profitably offer loans below a certain dollar threshold (e.g., below
$200,000). Many small businesses reported being denied credit because either the
owner's personal credit score had declined or the score no longer satisfied lenders'
heightened standards.
- In Boston and Cleveland, small business owners reported that their credit
scores declined after credit-limit reductions led to higher debt ratios, despite
the fact they were always current with payments. In some cases, the credit
score downgrades made it extremely difficult to borrow and resulted in
businesses' closure or bankruptcy.
- In Miami, business owners and intermediaries expressed concern that lenders
are placing greater emphasis on business owners' personal credit to
determine creditworthiness and denying credit to small businesses where the
owner has a good business plan but impaired credit.
Resource constraints - In addition to capital challenges, banks pointed to a number of
other constraints on their lending resources, such as the following:

Asset management challenges - Banks reported that higher-than-average
delinquency and loss rates have taxed their workout units, forcing them to shift
seasoned staff, including loan officers, to assist with the increased number of
problem loans. Some banks, particularly smaller banks, described a temporary
suspension of all lending activities while they assess portfolios, manage workouts
and distressed loans, and reevaluate collateral.

Regulatory burden - Smaller banks pointed out the difficulties involved in staying
abreast of new regulations and guidance, understanding them thoroughly, and
determining how to best implement them.
- Because of the complexity associated with administering new or revised
regulations, some community banks said that they often must assign senior
loan officers to handle the new rules, leaving more junior lenders to handle
new loans. Some small businesses commented that they are then left working
with junior loan officers who they believe do not understand their businesses,
are dismissive, or adhere mechanically to underwriting guidelines.
 -
Programmatic changes Bank lenders described how enhancements to Small
Business Administration (SBA) lending programs, including the increase in guarantee
authority and fee waivers, helped them to make loans they might not otherwise have
made. Credit unions also reported good success in using the 7(a) loan program,
which was in high demand. Suggestions for program improvements included an
SBA guarantee for loan modifications, more streamlined and faster loan processing,
and packaging assistance for the 7(a) program, similar to what is available for the
504 program.
- In meetings in Nashville and Tampa, several participants expressed the view
that uncertainty about the duration, availability, and conditions of SBA program
enhancements has made banks reluctant to invest the time to adapt to new
program requirements.

Impact on underwriting time - Banks frequently said that they do not have enough
time to handle applications with insufficient documentation, such as sparse tax
returns, inadequate income statements, or unreliable interim financial statements.
Participants noted that some banks significantly reduced or eliminated loans below a
certain threshold, typically $200,000, as a way to limit time-consuming applications
from smaller and less sophisticated businesses. Banks also cited the imbalance
between time commitment and returns as a reason for not participating in certain
SBA loan products, such as the America's Recovery Capital or 7(a) loan programs.
- In Miami, bankers noted that they were spending much more time on due
diligence than ever before. The bankers and technical assistance providers
agreed this is necessary in a market where fraud is prevalent. However, the
extended time it may now take to get a loan approved can hurt small
businesses.

Impact of bank closures - Small businesses raised the issue of credit availability
in areas that have experienced bank failures. If a financial institution is closed and
not replaced, the impact is particularly acute. Small businesses in rural areas and in
regions with few banks raised this issue most frequently.
- In St. Louis, participants described the challenge of "orphaned" loans, when a
bank that acquires a failed financial institution chooses not to continue the
relationship with the borrower, making future extensions of credit unlikely.
Regulatory environment - Some banks cited examination-related concerns as an important
factor in credit availability for small businesses. In addition to general statements attributing
tightened credit to increased regulatory scrutiny in light of recent economic conditions,
concerns were raised about examiner assessments and the uncertainty surrounding
classification of assets.

Restrictions on lending - Some bank participants noted that because of declining
asset values of their balance sheets, more banks have been required to raise capital
to cover potential losses. Among other strategies, banks can respond by taking on
fewer loans in order to meet the capital requirements or raising capital under
adverse economic conditions.
- In St. Louis, participants stated they were unsure whether examiners are
requiring a 5 percent tier-1 capital ratio standard or whether a stricter
7 percent standard is being applied.
- Some banks reported inconsistent treatment of loans by different regulators.
- Several banks mentioned that they consider their examiner's expected
response before making new loans. They also expressed reluctance to do
loan workouts because of concerns that examiners will still regard the loan as
being impaired.6
- In New York, Atlanta, and Miami, small businesses and other participants
expressed the view that banks are citing increased examiner scrutiny when
refusing to lend to certain industries, such as construction, real estate, and
retail services.
- Bank regulators stated that banks in South Florida have significant challenges
in maintaining adequate capital levels because of the higher loan-loss
reserves related to declining asset values.
 Conflicting messages - Some bank participants expressed frustration about their
perception of conflicting messages from different government stakeholders. On the
one hand, the banks feel pressure to lend, but at the same time they are
encouraged to apply stricter credit standards. The result is a more cautious
approach to lending.
- Several banks expressed concern about lending to small businesses that they
believe have the potential to grow when the economy begins to expand. Their
concern is that, although a business may have good prospects, regulators
may be wary of loans based on future prospects, particularly if the business
has less-than-perfect credit, a recent history of uneven cash flow, or reduced
collateral values.7
Use of alternative funding sources - Meeting participants noted that small businesses that
are denied, or perceive they will be denied, credit by banks have turned to alternative
sources of financing, which often carry a higher cost.

Increased use of credit cards - At many meetings, small businesses described
turning to credit cards in lieu of a bank loan. At the same time, many small
businesses also described how their credit limits were being reduced. After being
denied credit, many tapped their personal and business credit cards, particularly for
working capital or as a line of credit. Businesses described, and several banks
confirmed, that in some cases banks are recommending the use of credit cards in
response to requests for smaller loans. Others attributed the increased use of credit
cards to the relative ease of applying for and using a credit card as compared to the
time and effort required to secure a bank loan.
- Some businesses reported incurring additional costs in relying on credit cards.
A business owner in Cleveland reported that her bank line of credit, which
carried a 7 percent interest rate, was cut. She then turned to a credit card to
finance business transactions and subsequently saw the rate on the card
substantially increase above her line of credit rate.

Greater reliance on personal resources - Small business owners frequently
mentioned the need to use personal financial resources to replace business credit.
Personal credit cards, in particular, are often used because they are easily
accessed. Some small businesses said they also relied on home equity lines on
their personal residence or on retirement savings. Family and friends are another
source often mentioned for small business financing, particularly for start-ups.
Current economic challenges, however, have restricted the availability of these
sources.
- In Annapolis, a small business owner described being denied for a line of
credit because her revenues were down in the prior two years. When she
looked into refinancing an investment property to tap its equity, lenders said
they were not refinancing investment property. As a result, she relied on credit
cards and borrowed against her 401(k) savings for working capital.
- In Los Angeles, meeting participants indicated that Asian Pacific Islander (API)
small businesses rely heavily on personal real estate for their financing, and
the significant decline in residential property values has led to a reduction in
credit and rising delinquencies for API small business loans.
- Participants in several meetings expressed the view that minority-owned
businesses are generally less likely to have an established banking
relationship and thus are less likely to receive bank loans. They often turn to
friends and family for financing, particularly in the start-up phase.

Adjustment of payment terms - Small businesses reported adjusting payment
terms in order to preserve cash whenever possible - e.g., shortening payment terms
for customers and extending payment terms with suppliers. Small businesses stated
that their options were limited when their customers or suppliers, who may also be
cash-strapped, are larger firms or the government and thus have more leverage.
- In Milwaukee, a small business owner summarized the phenomenon:
"Receivables have gone up and we have passed that on by stretching our
payables. Some customers pay in 70 days, while others pay in 180. My first
recommendation: pass a law that says pay in 30 days or pay interest."

Alternative financial institutions - Many Community Development Financial
Institutions (CDFIs) and credit union participants noted an increase in small
business loan demand over the last two years. They expressed the view that this
may be the