Ben S Bernanke: The financial crisis and community banking
Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal
Reserve System, at the Independent Community Bankers of America's National Convention
and Techworld, Phoenix, Arizona, 20 March 2009.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
When I addressed this convention three years ago, with all of five weeks under my belt as
Chairman of the Federal Reserve Board, I opened my remarks with three observations: that
community banks played a critical role in the U.S. economy, that community banks were
generally doing well, and that community banks faced a changing business environment that
posed important challenges. I am struck that all three observations, at least to some degree,
still hold true today. Community banks continue to play a critical role in our economy and, in
many cases, have an opportunity to step in and make sound profitable loans, where some
competitors have pulled back. Relatively speaking at least, community banks are doing
better as a group than other segments of our financial system, but at the same time they are
far from immune to current conditions. And, surely, it is still true that the business
environment poses important challenges to community banks.
In fact, I think it is safe to say that few of us in the convention hall three years ago envisioned
the financial and economic environment we now confront. Envisioning the conditions we will
face three years from now is equally difficult, but it is my hope and expectation that those
conditions will be significantly brighter. This morning, I'd like to spend some time reviewing
the Federal Reserve's response to the financial crisis of the past 18 months, as well as the
current challenges - and opportunities - facing community banks. In addition, I'll discuss two
important steps that policymakers can and should take to improve the financial regulatory
system that likely are of particular interest to you. The first step is the need to address the
very real problem caused by institutions that are too big - or too interconnected - to fail in a
disorderly manner. The second involves ways of making the system less procyclical, so that
the financial system is less susceptible to exuberant booms and disastrous busts. In
discussing the road back to financial stability and economic prosperity, I want to leave you
with the idea that, yes, this is indeed a time of challenge for community bankers, as it is for
all Americans, but it also is a time of opportunity.
Federal Reserve actions to address the financial crisis
The depth and complexity of the strains that have gripped financial markets and institutions
since the summer of 2007 have led the Federal Reserve to take innovative and extraordinary
actions aimed at restoring stability to markets and supporting the flow of credit to businesses
and households.
Most directly, the Federal Open Market Committee (FOMC) has eased monetary policy
aggressively. From the second half of 2007 to the spring of 2008, the Committee reduced its
target for the federal funds rate from 5-1/4 percent to 2 percent. And, as the financial
turbulence intensified last fall and the economic outlook deteriorated, the Committee
responded by cutting the target for the federal funds rate to near zero by the end of last year.
As a result, a number of interest rates, especially shorter-term rates, have declined
significantly, offsetting, at least to some degree, the effects of the financial turmoil on the cost
of credit. However, as community bankers are no doubt aware, that offset has been
incomplete. Widening credit spreads, more-restrictive lending standards, and credit market
dysfunction are working against the monetary easing and leading to tighter financial
conditions overall. To address these problems, the Federal Reserve has employed a range
of additional tools.
These tools can be divided into three sets. The first set is closely tied to the central bank's
traditional role of provider of short-term liquidity to sound financial institutions. Over the
course of the crisis, the Fed has sought to ensure that financial institutions - including banks
of all sizes as well as primary dealers - have had adequate access to short-term credit.1 We
substantially reduced the spread of the primary credit rate over the target federal funds rate
and increased the maximum maturity of primary credit loans to 90 days; we have also been
conducting regular auctions of discount window credit for terms of up to 84 days. In fulfilling
this traditional lending function, we have helped ease conditions in interbank funding
markets, thus increasing the willingness of banks to extend loans and thereby easing credit
conditions for the households and businesses that depend on banks.
Despite our provision of liquidity to banks and broker-dealers, a number of critical nonbank
financial markets - such as the commercial paper market and the market for asset-backed
securities - deteriorated significantly. Under normal circumstances, these markets are
important sources of credit for American businesses and their customers. Thus, we
developed a second set of policy tools to provide liquidity directly to borrowers and investors
in key credit markets. Notably, we have introduced facilities to purchase highly rated
commercial paper at a term of three months and to provide backup liquidity for money market
mutual funds.
In addition, the Federal Reserve and the Treasury have jointly established a facility - the
Term Asset-Backed Securities Loan Facility, or TALF - that lends against AAA-rated
assetbacked securities collateralized by recently originated student loans, auto loans, credit card
loans, and loans guaranteed by the Small Business Administration. This program just got
under way; the first subscription for funding under the program was completed yesterday,
with the funds to be disbursed next week. Over time, we expect to expand this facility to
include loans against other types of newly issued AAA-rated asset-backed securities, such
as commercial mortgage-backed securities and private-label residential mortgage-backed
securities. If this program works as planned, it should make new consumer, business, and
mortgage loans more available, at lower cost.
The Federal Reserve's third set of tools for supporting the credit markets involves the
purchase of longer-term securities for the Fed's portfolio. As we announced this week, we
are purchasing up to $300 billion in Treasury debt, $200 billion of the debt of
governmentsponsored enterprises (GSEs), and up to $1.25 trillion of mortgage-backed securities
guaranteed by the GSEs and federal agencies this year. These purchases are intended to
improve conditions in private credit markets. In particular, they are helping to reduce the
interest rates that the GSEs require on the mortgages that they purchase or securitize,
thereby lowering the rate at which lenders, including community banks, can fund new
mortgages.
The Federal Reserve continuously assesses the effectiveness of its credit-related tools. So
far, we have generally been encouraged by the market responses, including the decline in
mortgage interest rates I mentioned. In addition, our commercial paper facility has helped
American businesses finance their payrolls and other operational obligations by significantly
lowering rates on the paper and opening access to financing at terms longer than a few days.
Our actions to stabilize the money market mutual fund industry, together with other
government programs, have also shown some success - the sharp withdrawals from funds
in September on balance have given way to modest inflows.
These credit-easing programs, along with actions taken by the Treasury and other
government entities, are crucial determinants of the timing and strength of the economic
recovery. However, although low interest rates and ongoing fiscal stimulus will help, we
cannot have a vigorous economic recovery unless we succeed in restoring a reasonable
degree of financial stability.
Conditions and outlook for community banks
As you well know, community banks have been adversely affected by the turmoil in the
financial system. As a group, community banks - which I define to include commercial banks
with assets of $1 billion or less - have seen their financial performance and condition
deteriorate substantially since the middle of 2007. Nevertheless, as I will discuss, the
longerterm outlook for community banks is positive in light of their unique competitive advantages.
Looking first at current conditions, higher loan loss provisions and significant realized losses
on investment securities - related in many cases to impairment of Fannie Mae and Freddie
Mac equity holdings - substantially eroded the profitability of community banks in 2008.
Community banks reported net income of just $4.6 billion, less than one-half of the level of
2007. In the fourth quarter, almost one in every three community banks reported a loss, and
overall they reported a small net loss of about $150 million. Community banks entered the
crisis with strong capital, and, despite weakening earnings, the vast majority - well over 95
percent - remained well capitalized at year-end 2008 under Prompt Corrective Action
standards. Nevertheless, the ratio of nonperforming assets to total assets rose to its highest
level since 1992 as residential mortgage and construction loans continued to deteriorate.
And given the near-term economic outlook, loan quality at many community banks may
decline further.
I know that bankers - including community bankers - have expressed concern over some of
the "mixed messages" they perceive are coming from the federal banking agencies in the
current environment - particularly admonitions to continue lending at the same time that
institutions are being urged to maintain adequate capital and prudent lending standards. We
are sensitive to this issue, which is why last November the agencies jointly issued the
"Interagency Statement on Meeting the Needs of Creditworthy Borrowers."2 In that
statement, we noted that continuing to lend in this environment is not inconsistent with
maintaining good risk management and high underwriting standards. For example, we
emphasized that, while rectifying past shortcomings in underwriting standards and other
aspects of risk management, banks can and should continue to provide loans to creditworthy
customers. We have directed our examiners to be mindful of the procyclical effects of
excessive credit tightening and to encourage banks to make economically viable loans,
provided such lending is based on realistic asset valuations and a balanced assessment of
borrowers' repayment capacities. Across the Federal Reserve System, we have implemented
training and outreach to underscore that direction.
In recent years, I and others from the Federal Reserve have underscored the importance of
community banks to the U.S. financial system and economy. I continue to believe that firmly.
Community banks serve businesses and consumers throughout the country, in both rural and
urban areas. They are a leading provider of credit to small businesses, a key source of job
creation in this country.
In the decades leading up to the current crisis, the nature of lending had changed
dramatically, with greater industry consolidation, increased economies of scale and scope,
and a larger portion of credit being supplied by nonbanks. While such changes challenged
community bankers, your institutions have remained vitally important. Indeed, during the
current crisis, some data show recent increases in loan and deposit balances at community
banks, while such balances are generally flat or even decreasing at the largest banks.
The various efforts that the Federal Reserve has taken to provide backup liquidity to financial
firms and to improve the functioning of financial markets have, I believe, helped all segments
of the financial system, including the community banking sector, and the economy more
generally. Helping community banks also helps the local communities that they serve. One
important way that community banks may assist their communities is by working with at-risk
homeowners to avoid preventable foreclosures. Foreclosures can result in clusters of vacant
properties, which in turn can foster crime, stretch municipal resources at a time of weakening
revenue, and lead to lower house prices throughout the neighborhood. These are some of
the reasons why the Federal Reserve, along with the other U.S. banking agencies, has
encouraged banks to participate in the Making Home Affordable loan modification program
established by the Treasury.
While continuing challenges remain, opportunities also exist for community banks. In some
instances, community banks are able to step in at crucial moments when local businesses or
consumers have been unable to find credit elsewhere. Indeed, as some banks have chosen
to cut back on lending to conserve capital and liquidity, community banks in strong financial
condition may find that they can gain creditworthy customers even in today's economic
environment. Such community banks also may find opportunities to reclaim customers and
business from nonbank lenders who have drawn back as the securitization markets have
encountered difficulties. Community banks are able to respond promptly in such cases
because of their in-depth knowledge of their markets, their locally focused management
teams and boards, and their commitment to tailoring unique credit products for individual
borrowers and businesses.
Addressing the "Too Big to Fail" problem
Many of you likely are frustrated, and rightfully so, by the impact that the financial crisis and
economic downturn has had on your banks, as well as on the reputation of bankers more
generally. You may well have built your reputations and institutions through responsible
lending and community-focused operations, but nonetheless, you now find yourselves facing
higher deposit insurance assessments and increasing public skepticism about the behavior
of bankers - outcomes that you perceive were largely caused by the actions of larger
financial institutions. Many of you managed your businesses prudently and shunned more
exotic instruments and activities. And many of your customers - households and businesses
- avoided excesses and are able to meet their financial commitments on a timely basis.
No doubt this frustration has been heightened by the problems caused by financial firms that
are too big or too interconnected to fail. Indeed, the too-big-to-fail issue has emerged as an
enormous problem, both for policymakers and for financial institutions generally. Creditors of
a firm perceived as too big to fail have less incentive to monitor and restrict the firm's
risktaking through adjustments to the price at which they lend money to the firm. If left
unaddressed, this weakening of market discipline creates an unlevel playing field for smaller
institutions, which may not be able to raise funds as cheaply, even if their individual risk
profiles are better, or at least no worse, than those of their larger competitors. The erosion in
market discipline distorts market behavior and can give firms an incentive to grow - either
internally or through acquisitions - in order to be perceived as too big to fail.
Government rescues to prevent the failure of major financial institutions also have required
large amounts of public resources. These actions have involved extremely unpleasant and
difficult choices, but given the interconnected nature of our financial system and the
potentially devastating effects on confidence, financial markets, and the broader economy
that would likely arise from the disorderly failure of a major financial firm in the current
environment, I do not think we have had a realistic alternative to preventing such failures.
That said, these episodes have shown clearly that the problem of too-big-to-fail is extremely
serious. To address this issue, which should be a top priority for financial reform,
policymakers will need to act on several fronts.
First, supervisors - as we are already doing - must vigorously address the weaknesses at
major financial institutions with regard to capital adequacy, liquidity management, and risk
management. Firms whose failure would pose a systemic risk must receive especially close
supervisory oversight and be held to the highest prudential standards. Aside from its direct
benefits for the safety and soundness of these large institutions, such an approach also
would help offset financial firms' incentive to grow until they are perceived to be too big to fail.
Second, supervisors must pay close attention to compensation practices that can create
mismatches between the rewards and risks borne by institutions or their managers. As the
Federal Reserve and other banking agencies have noted, poorly designed compensation
policies can create perverse incentives that can ultimately jeopardize the health of the
banking organization. Management compensation policies should be aligned with the
longterm prudential interests of the institution, be tied to the risks being borne by the
organization, provide appropriate incentives for safe and sound behavior, and avoid
shortterm payments for transactions with long-term horizons.3
Third, as the recent financial crisis has highlighted, risks to the financial system may arise not
only in the banking sector, but also from financial firms that traditionally have been outside
the regulatory and supervisory framework applied to banking organizations. Under federal
law, all banking organizations - regardless of size - are subject to consolidated supervision
for safety and soundness purposes. At a minimum, policymakers must ensure that a similar
statutory framework is put in place for all systemically important financial firms organized as
holding companies. The agencies responsible for implementing this framework also must
vigorously exercise their authority to help ensure the safety and soundness of nonbank firms
whose failure could threaten the stability of the financial system. Broad-based application of
the principle of consolidated supervision would also serve to eliminate gaps in oversight that
would otherwise allow risk-taking to migrate from more-regulated to less-regulated sectors.
Fourth, continued strong and concerted efforts are needed to improve the financial
infrastructure - or "plumbing" - that supports the trading, payments, clearing, and settlement
activities that are so critical to the functioning of the financial system. I have described
elsewhere the various steps that the Federal Reserve is taking in coordination with other
supervisors and market participants to improve the resiliency of over-the-counter derivative
markets and the market for triparty repurchase agreements.4 Improvements in these areas
should reduce the likelihood that the failure of any individual institution would have
substantial spillover effects on other financial institutions or the broader markets, and thereby
make it less likely that the government would need to intervene.
Finally, an important element of addressing the too-big-to-fail problem is the development of
an improved resolution regime in the United States that permits the orderly resolution of a
systemically important nonbank financial firm. We have such a regime for insured depository
institutions, but it is clear we need something similar for systemically important nonbank
financial entities. Improved resolution procedures for these firms would help reduce the
toobig-to-fail problem by giving the government the option of safely winding down a systemically
important firm rather than keeping it operating.
Reducing procyclicality in the financial system
In the current environment, financial institutions of all sizes are trying to meet the needs of
creditworthy borrowers while at the same time maintaining sufficient capital and other
resources to weather the ongoing crisis. Capital rules, accounting policies, and other
regulatory standards should not make this job even more difficult by encouraging excessively
procyclical behavior by financial institutions - that is, behavior that causes financial
institutions to tighten credit in downturns and ease credit in booms more than is justified by
changes in the creditworthiness of borrowers.
No one questions the underlying objectives of capital rules and accounting standards, which
are to ensure the safety and soundness of financial institutions and to accurately and
transparently disclose an institution's financial condition, respectively. However, some
aspects of existing capital rules and accounting standards may unduly magnify the ups and
downs in the financial system and the economy. For example, the capital rules require banks
to maintain capital ratios that meet or exceed fixed minimum standards. Because banks
typically find raising capital to be difficult in economic downturns or periods of financial
stress, their best means of boosting regulatory capital ratios during difficult periods may be to
reduce new lending, perhaps more so than is justified by the credit environment. Moreover,
as many institutions and auditors will attest, determining the appropriate valuation of illiquid
or idiosyncratic assets can be very challenging, especially in highly strained market
conditions. The economic downturn also has renewed the debate concerning the appropriate
levels of loan loss reserves over the cycle.
Institutions themselves often try to offset the potential for procyclicality in capital levels by
maintaining strong capital buffers to absorb swings in regulatory capital requirements. This
type of action is in line with supervisory expectations that call for banking organizations to be
able to assess their overall capital needs and hold capital commensurate with their individual
risk profiles - beyond complying with minimum regulatory capital requirements. Most
community bankers understand this point. Your institutions generally hold capital in excess of
minimum regulatory requirements - sometimes well in excess.
Nonetheless, the issues surrounding procyclicality are not easy, and their consideration will
require a careful balancing of important public policy interests. Policymakers should review
existing capital rules and accounting standards to determine whether these rules and
standards could be modified to reduce their potential to have unduly procyclical effects
without weakening their ability to achieve their fundamental objectives. I'm pleased to note
that the Basel Committee and the Financial Stability Forum already have work under way to
address excessive procyclicality in capital regulations, and that the Financial Accounting
Standards Board is issuing new guidance that relates to market-to-market accounting in
inactive markets and other-than-temporary impairments.
Conclusion
I want to conclude by encouraging you as community bankers to operate prudently in the
current environment, but not to let fear drive your decisions. You should all continue to
exercise good risk management - including strong underwriting for individual exposures and
proper management of credit concentrations in your portfolios. You should also be certain
that any deterioration in asset quality and borrowers' conditions are accurately identified,
measured, and managed. And you should take steps to maintain a strong financial condition
with sufficient capital and liquidity levels as preparation for any future economic and financial
uncertainty. By doing so, you can ensure that your institutions can continue to provide a
steady and consistent source of credit to businesses and borrowers for years to come. If
community banks are prudent but opportunistic in extending credit to strong borrowers, they
will help the economy recover while benefiting from that recovery themselves.