Elizabeth A Duke: Restoring credit to communities
Speech by Ms Elizabeth A Duke, Member of the Board of Governors of the Federal Reserve
System, at the fifty-third Annual Western Independent Bankers Conference, Scottsdale,
Arizona, 31 March 2010.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal Reserve
System's website.
* * *
Good Morning. I am pleased to be here today to address the Western Independent Bankers
Annual Conference. As many of you know, I spent most of my career as a community
banker. What you may not know is that I first became CEO of a community bank under an
unusual set of circumstances. I found myself in the CEO's seat unexpectedly, after the
sudden death of my mentor, the man who had taught me banking and with whom I had
started and built that bank carefully over the years. In addition, it was August 1991, which I'm
sure you will recognize as the peak of the last credit crisis.
It was a typical community bank. We loaned inside our market to customers who had been
with us for many years. As the economy weakened in the early 1990s, those customers
struggled and the value of their collateral dropped. Neither we nor our customers had caused
the crisis, but we still had to face it and deal with it. Throughout those challenging years, we
had some successful workouts and some that were not so successful. Sound familiar?
So, I have experienced banking crises from different perspectives throughout my career.
Having dealt with the last banking crisis as a banker, I understand the stress many of you
and many of your customers feel today. I also know firsthand the importance of recognizing
problems early and tackling them head on. Having experienced the more recent crisis at the
Fed, I can assure you that this environment is every bit as stressful for your regulators.
Even in the best of times, lending involves judgment. So does bank supervision. During times
of stress, the judgment calls get more difficult and more critical. An economy and its financial
system are inextricably intertwined and bank supervisors are charged with maintaining the
safety and soundness of the system without impeding the flow of loans to creditworthy
borrowers. The linkages that connect community banks, the communities they serve, and
their bank supervisors, are especially interwoven and essential.
Now I am happy to report that our bank and, for the most part, our customers pulled through
that crisis in the early 1990s. And I continued to lend to many of those same customers for
another 15 years. I am pleased to see that you have chosen as the theme for this conference
"Solutions for the Changing Environment" as it indicates confidence that you too will continue
to thrive and support your communities. For it is critical that you do so: Our economy needs
strong community banks that are able to meet the financial needs of their communities and
their customers.
In my remarks today, I intend to focus on your role as lenders. First, I will discuss commercial
real estate, the loan category that for most community banks is causing the most stress and
receiving the most attention. Then I would like to talk about credit availability for small
businesses, a key customer segment for community banks. Finally, I will offer some thoughts
about the role of supervisors in encouraging the flow of loans to creditworthy borrowers.
Throughout the discussion, I will focus on recent loan guidance issued by the Federal
Reserve along with our fellow banking regulators and the steps we at the Fed are taking to
ensure that the policies we set in Washington make it into the field to the examiners you see
in your banks.
Before I begin, I would like to make one point of clarification: When I reference community
bank statistics, I will refer to the segment of banks with less than $10 billion in total assets.
Banking and financial conditions
While conditions in some financial markets have improved markedly in recent months,
conditions in the banking sector continue to be weak. The largest banks were modestly
profitable during 2009, but community banks as a group reported a loss of $4.1 billion and
showed a negative return on assets of 0.17 percent. Community bank losses were driven
primarily by large loan loss provision expenses, as well as a decline in net interest margins
related in part to a substantial increase in nonperforming assets.
There are signs that these problems might be reaching a plateau in some loan categories,
but delinquencies and charge-off rates grew steadily last year and the nonperforming assets
ratio for community banks is now approaching five percent, a level considerably higher than
the previous highs reached in the late 1980s and early 1990s. In addition, although capital
ratios at many banks have improved substantially since the start of the crisis, other
institutions continue to face serious questions about capital adequacy due to weak loan
quality, subpar earnings, and uncertainty about future conditions. Together, these
developments have led to an increase in the number of problem banks to the highest level
since the early 1990s. The rate of bank failures has accelerated and appears likely to remain
elevated for some time. While most banks remain sound, appropriately capitalized, and
profitable, this can be difficult to remember in the midst of strained banking conditions and
weekly bank failures.
The coordinated efforts and initiatives of the Federal Reserve, the U.S. Treasury
Department, and other government agencies have contributed to the progress we have
achieved in stabilizing the financial markets and the banking system. I think it is important to
note that most of these efforts were directed at the system as a whole and were made
available to banks of all sizes.
For example, in September 2008, when a prominent money market fund "broke the buck"
(that is, its net asset value fell below one dollar), the Treasury Department initiated a
temporary guarantee program to avert a run on other money market mutual funds. Then, in
response to bankers' concerns about the adverse impact that unlimited guarantees for
money market funds would have on bank deposits, the Treasury adjusted the guarantee to
cover only balances in place on the date the guarantee was issued. That is, funds that were
already in the money market mutual fund accounts were guaranteed so they would not run
out, but no guarantee was offered for new investments that might cause runs out of
depository institutions and into the funds. A few weeks later, the deposit insurance limit was
temporarily increased to $250,000, an increase that had long been sought by community
banks.
In addition, under the Temporary Liquidity Guarantee Program (TLGP), the Federal Deposit
Insurance Corporation (FDIC) made available unlimited insurance for demand deposits.
Later the program was modified to also cover Interest on Lawyers Trust Accounts (IOLTAs)
and low-interest Negotiable Order of Withdrawal (NOW) accounts. These initiatives proved
tremendously beneficial to community banks and their small business customers during the
crisis and have been instrumental in returning some measure of stability to deposit markets.
Other efforts to calm markets were also designed to directly assist banks of all sizes. For
example, more than three-fourths of the companies that received funds from the Troubled
Asset Relief Program (TARP) capital purchase program were, in fact, community banks. In
addition, the Debt Guarantee Program put in place by the FDIC under the TLGP has also
been available to community banks, helping to support market confidence. And the Federal
Reserve's discount window lending as well as the Term Auction Facility, which offered
discount window funding through auctions, were available to banks regardless of size and
benefited community as well as larger banking organizations.
Looking back over the past two years, I have reached the conclusion that these programs,
taken as a whole and combined with other steps taken by policymakers and bankers
themselves, have had a dramatically positive effect on financial conditions and have brought
us far beyond the near panic that we experienced in the latter half of 2008. Importantly, these
initiatives were in many cases tailored to ensure that they were available to, and supportive
of, community banks. So although I understand that there will be significant additional
challenges ahead to improve the condition and performance of community banks, you can
take some comfort in knowing that policymakers are aware of the importance of your
institutions and are sensitive to the unique challenges that you face.
Improving lending conditions
All of these measures have helped foster stability in the financial system. However, banks
still have significant delinquencies in their loan portfolios and some small businesses and
consumers still report trouble obtaining credit. In addition, although loan balances at the
smallest banks - those with total assets of $1 billion or less - in the aggregate fell only
modestly during 2009, loans outstanding for all other banks dropped more sharply. Some
observers attribute this decline in loans outstanding to overzealous bank examiners, but I
believe the causes are numerous and more complicated. Regardless of the cause, the
decline is of great concern and we must work together to reverse the trend. As the financial
crisis unfolded, the Federal Reserve, in collaboration with the other banking regulators,
issued lending guidance on three occasions, stressing the need for balance in the
approaches used by bankers to approve loans and by bank examiners in reviewing loans:

in November 2008, regulators issued guidance stressing the importance of
continuing to make prudent loans to creditworthy customers;1

in October 2009, the agencies issued guidance covering commercial real estate
(CRE) loans and workouts;2 and

in February of this year, we issued guidance regarding loans to small businesses.3
Commercial real estate loans and workouts
The ongoing deterioration in commercial real estate loans is perhaps of greatest concern for
community bankers. These loans make up more than 30 percent of community bank assets
and have deteriorated sharply as fundamentals in property markets have weakened.
Performance problems have been most striking in construction and development loans,
especially for those that finance residential development, but have been significant in other
loan segments as well. Altogether, CRE loans seriously delinquent, on nonaccrual status, or
held as other real estate owned (OREO) - including all construction loans, loans secured by
nonfarm nonresidential properties, and loans secured by multifamily properties - represented
nearly eight percent of commercial real estate loans and related OREO at year-end 2009,
and almost one-quarter of the total risk-based capital at community banks.
Given the risks associated with CRE lending, banking agencies have for the past several
years focused on assessing community bank exposures to commercial real estate and
pushing institutions to enhance their risk-management processes for this segment of their
portfolios. As problems surfaced we recognized that loan restructurings are often in the best
interest of both the bank and the borrower and encouraged banks to explore opportunities to
work with their borrowers to appropriately restructure problem loans.
My recent conversations with bankers have been heavily focused on concerns about loan
classification standards. Some of you have told me that you feel that examiners are not
always taking a balanced approach to the assessment of commercial real estate loan
restructurings. On the other side of the table, I hear from examiners that they feel some
banks have been slow to acknowledge declines in commercial real estate project cash flows
and collateral values. The new guidance is intended to bridge this apparent gap in
perceptions and to promote both prudent commercial real estate loan workouts by banks and
balanced and consistent reviews of these loans by the supervisory agencies.
The October 2009 CRE guidance includes a number of examples drawn from common loan
situations and specifies classification treatment for alternate scenarios that depend on
actions taken by the bank and the borrower. As we were finalizing the guidance, I sat down
with our supervision staff and went through each of the examples as if we were in a loan
closing conference. Based on what was discussed during those conversations and my close
reading of the guidance, I think the best way to bridge the gap in perception is through
welldocumented facts. For example, to support the value of a construction project, the bank
would need current information on the project status, including an estimate of the cost to
complete. It would also need documentation of the method of realizing value for the
completed project. For instance, if the borrower has a take-out permanent loan commitment,
the file should include an update on the status of the commitment including any conditions to
closing. If the property is under a sales contract, the bank should document the buyers'
continued willingness and ability to close. If the bank is relying on other resources of
borrowers or guarantors for repayment, it should have global cash flow information to be able
to assess their ability to continue to carry the loan until conditions improve. The fact that the
loan has a good payment history and is performing is important, but not sufficient to make
the case that resources are available to keep it current in the future. Finally, the bank should
have either a current appraisal or sufficient current market information to credibly update the
assumptions in the most recent appraisal. If market conditions are changing rapidly, "current
information" may need to be more up-to-date than is usually the case. Examiners generally
are not expected to challenge the underlying valuation assumptions, including discount rates
and capitalization rates, used in appraisals or evaluations when these assumptions differ
only in a limited way from norms that would generally be associated with the collateral under
review.
Loans will be classified and valued on the basis of cash flow first, and collateral value
second. Assessments of cash flow and valuation will be much more reliable if based on solid
documentation. In the absence of documentation, examiners will have to make assumptions.
Most loans should fall into one of three categories:

First, if available cash flow, including the willingness and ability of any guarantors to
provide cash support, is sufficient to carry a construction project to completion or to
amortize a completed project on reasonable terms at a market rate of interest, the
loan should not be classified;

If, on the other hand, there is no available cash flow to carry the loan and repayment
can only come from the sale of the collateral, an amount equal to the value of the
collateral less selling expenses will be classified and any remaining amount charged
off; and
 Finally, if cash flow is sufficient to partially amortize the loan, the bank may be able
to restructure the loan into two parts, one of which is supported by cash flow and
therefore a pass, and the second of which is less supported and so would be
classified.
This guidance is designed to address workouts and restructurings of problem credit, but the
clarification of loan classification standards should also give bankers some confidence in
evaluating new loans for both credit risk and risk of classification. Overall, the guidance urges
both lenders and examiners to take a balanced approach in assessing borrowers' debt
servicing capacity and to make realistic assessments of collateral valuations.
Importantly, at the Federal Reserve we have complemented these issuances with training
programs for examiners and outreach to the banking industry to underscore the importance
of sound lending practices. In January, Federal Reserve staff instituted a System-wide
examiner training initiative that will reach Federal Reserve and state examiners all across the
United States. Additionally, an interagency training program has been developed specifically
for examiners reviewing CRE loans as part of the interagency Shared National Credit
Program, which includes the largest commercial real estate loans in the nation.
We are working hard to track the progress and effectiveness of this guidance. Before issuing
the guidance, Federal Reserve staff surveyed examiners to gain a better understanding of
the banks' workout practices. Going forward, the information that we collected will serve as a
baseline for assessing the impact of the supervisory guidance. We also are asking
examiners to capture, where possible, information on troubled debt restructurings and other
types of loan workouts and dispositions as part of the ongoing examination process. In
addition, we are exploring the feasibility of more formal statistical approaches for measuring
and evaluating the effectiveness of the November 2009 interagency CRE workout and
restructuring policy statement. We continue to receive and evaluate comments and feedback
from supervised banks and I can assure you we will consider the need for adjustments if
feedback suggests they are needed.
Small business lending
Now I would like to turn to small business lending. Small businesses are, in many cases, the
most important customer segment for community banks. And because community banks are
an important source of credit for small businesses, their challenges and their fates are
closely linked. Despite the best efforts of bankers and regulators, we continue to hear of the
difficulties experienced by small businesses in obtaining credit. A recent study conducted by
the National Federation of Independent Business (NFIB) found that of small employers who
attempted to borrow in 2009, about half received all the credit they wanted. But nearly
onequarter received no credit at all. A similar study in 2005 found nearly 90 percent of small
employers had most or all their credit needs met and only eight percent obtained no credit.
Even though conditions in financial markets have continued to improve in 2010, access to
credit remains restricted for many smaller businesses, who largely depend on banks for
credit. Risk spreads on small business loans at banks have continued to rise, and the decline
in loans outstanding has been stark.
A number of factors are contributing to the reduced supply of bank loans. For instance, in
response to an increase in the number of delinquent and nonperforming loans, many banks
have reduced existing lines of credit sharply and have tightened their standards and terms
for new credit. In other cases, banks with capital positions that have been eroded by losses
or those with limited access to capital markets may be reducing risk assets to improve their
capital positions, especially amid continued uncertainty about the economic outlook and
possible future loan losses.
A number of government programs intended to increase the supply of credit are currently in
place or under consideration and a variety of approaches may be needed to address the
different barriers to bank lending. For example, to offset bank concerns about the level of
credit risk, increases in the availability of Small Business Administration (SBA) guarantees
and streamlining of the SBA application process may be helping to increase bank lending to
small businesses. Indeed, in recent testimony before the House Financial Services
Committee, the SBA reported significant growth in the number of banks using its programs.
If, on the other hand, community bank lending is restricted by concern about capital
positions, the Treasury proposal to transfer $30 billion from TARP to establish a Small
Business Lending Fund (SBLF) could stimulate lending by providing capital without the
perceived stigma or conditions of TARP and at a lower cost to community banks that
increase small business lending. If approved, the program would also allow community
banks that received capital in the original TARP program to convert to SBLF and lower their
interest payments by increasing loans to small businesses, something many are already
doing.
The reduction in the availability of credit, however, is not the whole story. There is also less
demand for credit by sound firms. As businesses reduced inventory levels and capital
spending, they tended to pay down debt and build cash positions. Indeed, in the most recent
NFIB study, 34 percent of businesses reported lower sales as their biggest problem while
only 3 percent cited lack of credit. And while some potential borrowers seek less credit,
others are no longer qualified to borrow. Weakened balance sheets, reduced income, falling
real estate collateral values, and in some cases, a recent history of payment problems, have
made it difficult for some businesses and consumers to qualify for loans, especially under the
current stricter standards.
Other factors unique to the current financial environment may also be weighing on the ability
of small businesses to borrow. A significant fraction of small businesses rely upon personal
assets and consumer credit to fund their operations. Thus, small businesses are affected by
tight conditions for consumer credit in addition to those for business credit. Many small
businesspeople rely on their homes or business real estate to secure their business loans.
As collateral values have declined, their borrowing capacity has been reduced. Finally, small
business lending often is based on relationships that are solidified over time. Sometimes
those relationships are broken as a result of the bank's inability to lend, such as when banks
fail or when they reduce lending due to strains or concentrations in their own portfolios. In
those circumstances, small businesses may find it quite difficult to establish similar
arrangements with a new bank.
Improvements in a number of the conditions that depressed lending in 2009, however, lead
me to be somewhat optimistic that we will begin to see an increase in bank loans later this
year. Economic conditions, the most important determinant of the demand for and availability
of small business lending, have improved considerably since the early and middle part of last
year. In response, bank attitudes toward lending, including small business lending, may be
shifting. In the Federal Reserve's Senior Loan Officer Opinion Survey conducted in January,
the number of banks that reported having eased credit standards for small business lending
over the previous three months about matched the number that reported having tightened
lending standards for the first time since before the crisis began, in the summer of 2007.
Restoring the flow of credit in the economy
Ultimately, the most important step policymakers can take to support community banks and
improve credit availability to small businesses, as well as other businesses and households,
is to achieve a sustainable economic recovery. Over the course of the past two years, the
Federal Reserve has taken aggressive action in response to the financial crisis to help
improve financial market conditions and to promote the flow of credit to households and
businesses. We have acted on multiple fronts by instituting accommodative monetary policy,
expanding existing liquidity programs for depository institutions, and establishing new
liquidity facilities to support market functioning. Throughout this period, the Federal Reserve
has placed particular emphasis on ensuring that its supervision and examination policies do
not inadvertently impede sound lending to businesses, both large and small, and we will
continue to do so. Actions taken to stabilize the largest banks during the crisis have received
a lot of attention. However, I think it is equally important to note the degree to which banks of
all sizes were offered access to the same loan, guarantee, and capital facilities. We should
never forget that the objective was to save the system as a whole, not just a handful of large
institutions. As attention turns from saving the financial system to strengthening it, any
proposed solution must address the assignment of responsibility for regulation and
supervision. During the financial crisis, I saw firsthand how important it was that the Fed have
a complete view of the financial landscape and how successful was the interaction among
the Fed's divisions in crafting solutions to the many different problems we confronted.
As of the end of 2009, the Federal Reserve supervised 4,974 top-tier bank holding
companies, 844 state member banks and 177 foreign banking organizations operating in the
United States. State member banks range from very small community banks to banks with
assets of more than $100 billion. Bank holding companies vary similarly in size and now
include a number of companies with more of their financial business outside of bank
subsidiaries than inside them. I believe that having a window into such varied parts of our
financial system is important and that it would be a mistake to focus Fed supervision on only
the largest companies.
Our strengths as a supervisor include our experience in supervision, knowledge of the
markets, and understanding of the economy. And our role in supervision strengthens our
performance in other roles. Lending issues have been central to our discussions of monetary
policy, at least in my time with the Fed. If you look at the maximum amount reached by each
of our lending facilities, we loaned almost $2 trillion in a very short time as we worked to
stabilize financial markets. Those loans are now paid down to less than $100 billion. We
never could have done that as quickly, as smoothly, or with zero loss without an extensive
knowledge of the industry and institutions as well as staff across the country with banking
expertise.
Conclusion
In summary, the recent financial crisis has underscored the importance of community
banking, especially the role you play in providing credit to the local businesses in your
community. Even though the environment is challenging and some community banks face
significant stress, most community banks are fundamentally sound and will remain so. It is
encouraging to see in your conference agenda that you are looking forward to returning to a
more stable model of community banking, one focused on prudent underwriting,
riskappropriate pricing, portfolio diversification, and stable deposit funding.
At the Federal Reserve we will continue to work to strengthen the economy and to ensure
that our supervision and examination policies do not inadvertently impede sound lending by
community banks. As we do so, it is important that we hear from you about the economic
conditions in your communities and any problems you face in meeting the needs of
creditworthy borrowers.
I thank you again for the invitation to join you today and look forward to your questions or
comments.