Ben S Bernanke: Banks and bank lending - the state of play
Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the Federal Reserve
System, at the 48th Annual Conference on Bank Structure and Competition, Chicago, Illinois
(via satellite), 10 May 2012.
* * *
I am pleased to speak this morning at what has become, over nearly 50 years, perhaps the
most prestigious conference for bankers, academics, and bank supervisors in the United
States. The first part of my remarks will highlight the significant progress that has been made
over the past several years toward restoring the banking system to good health. I will also
talk about some of the challenges banks face as they adapt to the post-crisis economic and
regulatory environment. I will then review recent trends in credit conditions, noting that bank
lending has generally been improving but remains restrained in some areas.
The state of the banking system
Since the financial crisis, banks have made considerable progress in repairing their balance
sheets and building capital. Risk-based capital and leverage ratios for banks of all sizes have
improved materially and are significantly above their previous highs. Importantly, the
19 largest banking institutions that participated in the 2009 stress tests, as well as the two
subsequent Comprehensive Capital Analysis and Review (CCAR) processes, have
considerably more and better-quality capital than a few years ago. Indeed, those firms have
increased their Tier 1 common equity, the best buffer against future losses, by more than
$300 billion since 2009, to nearly $760 billion. The Tier 1 common ratio for these firms, which
compares this high-quality capital to risk-weighted assets, stood at 10-1/2 percent at the end
of last year.
The latest CCAR, conducted earlier this year, demonstrated that most of the 19 firms would
likely have sufficient capital to withstand a period of intense economic and financial stress
and still be able to lend to households and businesses. The hypothetical supervisory stress
scenario used in the CCAR was quite severe; it included a peak unemployment rate of
13 percent, a 50 percent drop in equity prices, and a 21 percent further decline in housing
prices, as well as steep falls in prices of financial assets most exposed to conditions in
Europe. Under this highly adverse scenario, the 19 bank holding companies were projected
to incur aggregate losses of more than $500 billion through the fourth quarter of 2013.
Nevertheless, their aggregate Tier 1 common ratio was projected to be 6.3 percent at the
end of the scenario period, and 15 of the 19 bank holding companies were projected to
maintain capital ratios above all four of the regulatory minimum levels - even after taking into
account their proposals for capital actions such as dividends, share buybacks, and share
issuance in the baseline scenario.
The banking sector overall also has substantially improved its liquidity position over the past
few years. Indeed, large banks in the aggregate have more than doubled their holdings of
cash and securities since 2009. Large banks have reduced their collective dependence on
short-term wholesale funding, and many are flush with retail deposits, which tend to be a
more stable funding source. Challenges on the liquidity front remain, however: Some large
firms still rely heavily on wholesale short-term funding; and the liquidity needs of the banking
system as a whole may become somewhat higher for a while as some of the securities
issued under the Federal Deposit Insurance Corporation's Temporary Liquidity Guarantee
Program come due, and as the unlimited insurance on noninterest-bearing transaction
accounts expires at the end of the year. Nevertheless, over time, greater liquid asset
positions and reduced dependence on wholesale short-term funding, together with more and
better capital, will make the banking sector less susceptible to unexpected disruptions in
short-term funding markets.
The credit quality of large banks' assets is looking better as well, although the improvements
have been uneven across types of loans. In the aggregate, delinquency rates on loan
portfolios at large banks have declined substantially from their peaks. However, while
delinquencies on commercial and industrial (C&I) loans and consumer loans have fallen to
the lower end of their historical ranges, delinquencies on loans backed by commercial or
residential real estate have declined only moderately and remain elevated.
The profitability of large banks has been edging up as credit quality has firmed and banks
have trimmed noninterest expenses. Even so, large banks' profitability remains well below
the levels that prevailed before the financial crisis began, and banks continue to struggle to
expand their revenues. Developments that can be traced back to the financial crisis
- including a still-weak economy, changes in market conditions and practices, and tighter
financial regulations - are clearly important reasons for these trends.
Community banks play important roles in local economies, and so it is notable that their
condition has also improved. Their regulatory capital ratios have increased significantly since
2009 and stand well above their recent norms. As has been the case at large banks,
delinquency and charge-off rates at community banks have declined across most major
categories of loans, and fewer institutions failed in 2011 than in each of the previous two
years. That said, clusters of small bank failures can affect credit availability in a community
while bank-dependent borrowers work to establish new relationships with surviving
institutions. In addition, while standard measures of community banks' profitability, such as
return on equity and assets, improved last year, as was also true at larger institutions, most
of the gains were due to reductions in loan loss provisions rather than to more sustainable
sources of profit such as expanded lending.
Financial-market indicators reflect the substantial improvements in banks' financial conditions
since the crisis as well as the sizable challenges remaining. Bank credit default swap (CDS)
premiums are now well below their crisis peaks, and bank stock prices have retraced some
of their earlier losses and have outperformed the broader market this year, boosted
somewhat by the release of the CCAR results in March and first-quarter earnings that largely
beat analysts' expectations. However, CDS premiums remain elevated for some of the
larger, more globally connected firms, and their stocks continue to trade at market-to-book
ratios of less than 1.
A number of key systemic risk measures that evaluate the potential performance of firms
during times of financial market stress have improved in recent months. These indicators of
systemic risk are now well below their levels in the crisis, and, overall, they present a picture
of a banking system that has become healthier and more resilient.1
Regulatory and financial challenges
Banks face a number of significant challenges as they adapt to the post-crisis economic
environment and to new domestic and international regulatory requirements. The most
systemically important financial firms will face meaningfully higher capital and liquidity
requirements and continue to undergo regular supervisory stress tests. They will also be
required to submit so-called living wills to facilitate their orderly resolution if necessary.
Additionally, banks must enhance their reporting systems and improve disclosure. These
new requirements are critical to safeguard the stability of the financial system and to help
prevent another costly crisis. At the same time, regulators appreciate that the new rules
impose significant burdens on banks. For that reason, and to minimize adverse effects on the
supply of credit, many of the most significant rules are being phased in gradually and only
after extended processes of consultation with industry and other stakeholders.
It is worth reiterating that most of these enhanced regulatory and supervisory measures
focus on the largest, most interconnected financial institutions, and we are working to ensure
that community banks are not subjected to rules designed primarily to constrain risks at
larger institutions. We have an ongoing dialogue with community banks through many
channels, including, for example, our Community Depository Institutions Advisory Council.
The council, whose membership is drawn from smaller banks, credit unions, and savings
associations in each of the 12 Federal Reserve Districts, meets with the Board in
Washington twice a year to discuss supervisory and regulatory issues that affect their
institutions. We have also established a special supervisory subcommittee of the Board
which focuses on community banking issues.
In addition to strengthened regulatory and supervisory requirements, banks face market
demands that they operate with more resilient business models. In many contexts,
counterparties are demanding greater security in the form of more and better-quality
collateral or higher margins. In addition, lenders to banks may be requiring greater
compensation for risk, thereby raising banks' funding costs.
Banks have also been navigating an economic recovery that has been halting at times.
Consequently, although the condition of the banking system is improving, demand for credit
generally has remained sluggish, and the creditworthiness of some borrowers that would
normally turn to banks for loans remains impaired. These factors, together with tighter credit
policies imposed by many lenders, have restrained somewhat the expansion of bank credit.
Credit conditions and bank lending
Notwithstanding the various headwinds, credit conditions in the United States have improved
significantly in a number of areas. Many - though certainly not all - businesses and
households are finding it easier to borrow than they did a few years ago, in part because of
better conditions in financial markets more broadly. Large businesses with access to capital
markets have generally been able to raise funds at attractive terms, with both
investment- and speculative-grade firms taking advantage of historically low interest rates to
issue bonds at a robust rate. Moreover, consumers with strong credit histories have ready
access to credit cards and auto loans, supported by solid issuance of consumer-related
asset-backed securities.
Banks also supply credit by purchasing securities, and their purchases have grown rapidly in
recent months - in particular, those of agency-guaranteed mortgage-backed securities
(MBS). In this challenging time for housing markets, banks are attracted by the securities'
government guarantee. Additionally, some larger banks may be accumulating these
securities in preparation for more-stringent liquidity regulations.
Signs of improvement notwithstanding, credit conditions in some sectors and for some types
of borrowers remain tight. Mortgage lending is an important example. Since its peak,
U.S. home mortgage credit outstanding has contracted about 13 percent in real terms. Many
factors suggest that this situation will be difficult to turn around quickly, including the slow
recovery of the economy and housing market, continued uncertainty surrounding the future
of the government-sponsored enterprises (GSEs), the lack of a healthy private-label
securitization market, and cautious attitudes by lenders.
Financing conditions in the commercial real estate sector also remain strained as
fundamentals, including high vacancy rates, depressed property prices, and the poor quality
of existing loans, continue to be weak. Moreover, the market for commercial MBS - a source
of liquidity for some lenders in this sector - is still struggling to regain its footing.
The Federal Reserve's quarterly Senior Loan Officer Opinion Survey on Bank Lending
Practices (SLOOS) offers a more-nuanced view of how lending terms are changing. The
SLOOS indicates that standards and terms in many loan categories have eased somewhat
further in recent quarters from the very tight conditions that prevailed earlier in the recovery.2
For example, the April SLOOS pointed to the first material net easing in lending standards for
commercial real estate loans since 2005 and to a further easing of standards for most types
of consumer loans. In addition, SLOOS respondents suggested that stepped-up competition
has induced a large number of domestic banks to reduce fees and spreads on C&I loans to
firms of all sizes. The SLOOS also indicates that demand for many types of loans has
continued to increase, with demand for C&I loans having risen to relatively high levels.
Consistent with the results of the SLOOS, C&I lending has indeed been rising sharply lately.
Banks have focused on C&I lending because business borrowers' creditworthiness is
improving and because the majority of C&I loans carry floating interest rates that reduce
interest rate risk. In addition, domestic banks reportedly are picking up customers as a result
of a pullback by some European institutions. Auto lending also has reportedly been solid,
reflecting strong fundamentals in auto markets - such as robust demand for used cars and
relatively low delinquency rates on existing auto loans. The strong fundamentals for auto
loans in turn also appear to have contributed to an easing of lending standards and terms.
But, as I mentioned earlier, residential mortgage lending has been particularly sluggish. Tight
lending standards and terms remain especially evident. To be sure, a return to pre-crisis
lending standards for residential mortgages wouldn't be appropriate; however, current
standards may be limiting or preventing lending to many creditworthy borrowers. For
instance, in the April SLOOS, we asked banks a hypothetical question about their willingness
to originate GSE-eligible mortgages relative to 2006 for borrowers with a range of credit
scores and available down payments. The SLOOS found that even when the loans were
accompanied by a 20 percent down payment, many banks were less likely to originate loans
to borrowers with given GSE-eligible credit scores, despite the originating bank's ability to
sell the mortgage to the GSEs. Most banks indicated that their reluctance to accept mortgage
applications from borrowers with less-than-perfect records is related to "putback risk" - the
risk that a bank might be forced to buy back a defaulted loan if the underwriting or
documentation was judged deficient in some way.
Small businesses owners, who in the past might have tapped into the equity in their homes
or used their homes as collateral for small business loans, also have found conditions
challenging in recent years. The stock of small loans to businesses on bank balance sheets
at the end of last year was more than 15 percent below its peak in 2008. These loans looked
to have ticked up in the fourth quarter of 2011, consistent with the reported increase in
demand for loans by small firms in the SLOOS. Responses to the monthly National
Federation of Independent Business survey also suggest some modest improvement in the
small business sector: The share of respondents reporting a need for credit has moved up
from lows of recent years, and the net share of respondents who say that credit is more
difficult to obtain than it was three months ago is notably below its peak in 2009.
The Federal Reserve is keenly interested in understanding how shifts in loan supply, loan
demand, and borrower quality may be affecting lending and, by extension, the broader
economy. Of course, sorting out the relative effect of changes in loan demand from the effect
of changes in loan supply can be quite difficult because they can be influenced by the same
factors. For example, a shift in the economic outlook can affect both the willingness of banks
to lend and the desire and ability of firms and households to borrow.
Recent research at the Federal Reserve examines cyclical changes in banks' lending
standards as reported in the SLOOS - a commonly used indicator of loan supply. It attempts
to assess how much of those changes were a "typical" response to macroeconomic and
bank-specific factors, and how much was "atypical" or unexplained.3 This analysis suggests
that the tightening of lending standards that occurred between 2007 and 2009 was much
greater than a model based on historical experience would predict, contributing to the
subdued pace of lending. These results are consistent with other evidence that the crisis
induced exceptionally high levels of risk aversion and uncertainty on the part of both lenders
and borrowers, constraining the flow of credit. As these factors have receded and the
economy has improved, lending standards have become less stringent.
Some bankers and borrowers believe that enhanced supervision and regulation has made it
more difficult for banks to expand their lending. The Federal Reserve takes seriously its
responsibility to ensure that supervisory actions to protect banks' safety and soundness do
not unintentionally constrain lending to creditworthy borrowers, and we have taken a variety
of steps to address these concerns. For example, we have issued guidance to supervisors
stressing the importance of taking a balanced approach to supervision and of promptly
upgrading a bank's supervisory rating when warranted by a sustainable improvement in its
condition and risk management. Some analysis has indicated that, all else being equal,
banks with lower supervisory ratings tend to lend less; prompt upgrades by supervisors when
such upgrades are appropriate may thus ease an unnecessary constraint on lending. Indeed,
in the fourth quarter of 2011 and the first quarter of this year, the number of ratings upgrades
for banks and bank holding companies supervised by the Federal Reserve exceeded the
number of downgrades. The last time that upgrades exceeded downgrades was in 2005. In
addition, we have stepped up examiner training on relevant lending issues, and we have
emphasized to examiners that an open dialogue with bank management is essential.
We have also looked into specific concerns raised about the examination process and its
effect on banks' willingness to lend. For example, during 2011, we reviewed commercial real
estate loan classification practices to assess whether examiners were properly implementing
the interagency policy statement on workouts of commercial real estate loans. We analyzed
documentation for more than 300 loans with identified weaknesses in six Federal Reserve
Districts. We found that Federal Reserve examiners were appropriately implementing the
guidance and were consistently taking a balanced approach in determining loan
classifications. Moreover, the documentation we reviewed indicated that examiners were
carefully considering the full range of information provided by bankers, including relevant
mitigating factors, in determining the regulatory treatment for the loans.
Conclusion
To sum up, conditions in the banking system - and the financial sector more broadly - have
improved significantly in the past few years. Banks have strengthened their capital and
liquidity positions. The economic recovery has facilitated the rebuilding of capital and helped
improve the quality of the loans and other assets on banks' balance sheets. Nonetheless,
banks still have more to do to restore their health and adapt to the post-crisis regulatory and
economic environment. As the recovery gains greater traction, increasing both the demand
for credit and the creditworthiness of potential borrowers, a financially stronger banking
system will be well positioned to expand its lending. Improving credit conditions will in turn
help create a more robust economy.