Donald L Kohn: Condition of the banking system
Testimony of Mr Donald L Kohn, Vice Chairman of the Board of Governors of the US Federal
Reserve System, before the Committee on Banking, Housing, and Urban Affairs, US Senate,
Washington DC, 5 June 2008.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal Reserve
System's website.
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Chairman Dodd, Ranking Member Shelby and members of the Committee, it is my pleasure
to appear today to discuss the condition of the U.S. banking system, as a follow-up to the
testimony I gave at a hearing held by your Committee in early March. In my remarks today, I
will provide an updated view of the health of the U.S. banking system, discuss some key
lessons learned from recent events, and then outline a few important areas in which the
Federal Reserve is responding in its role as banking supervisor.
Within the past year, we have seen a number of banking institutions suffer losses, some
quite substantial. These and other institutions have been facing a range of risk management
challenges, some of them relatively fundamental in nature and others associated with the
increased use of complex and relatively new products. Fortunately, bank managers are
acting on lessons learned from recent events and taking steps to rectify identified problems.
Supervisors are also taking steps to respond to lessons being learned from recent events
and, where appropriate, enhancing supervisory processes. Some of these steps include
enhancing our understanding of the adverse implications of greater complexity in financial
products and markets, stepping up our continuing efforts to address the challenges
associated with supervising large, complex consolidated entities by multiple regulatory
agencies, and ensuring that we continue to send strong supervisory messages, in good
times and bad.
Condition of the banking system
As you know, the Federal Reserve is responsible for supervising bank holding companies,
working together with the primary supervisors of the banks and their affiliates. We ourselves
are the primary supervisors of state-chartered banks that choose to join the Federal Reserve
System. My update on banking conditions will focus on these two groups of banking
organizations.
As the U.S. housing market has weakened and the economy has slowed over the past year,
banking organizations have recognized significant losses stemming both from higher credit
charges against residential mortgage-related loans held on their books and sharp asset
value write-downs of securitized mortgage-related positions and leveraged loans. Indeed, the
50 largest bank holding companies, which represent more than three-fourths of all bank
holding company assets, reported losses of more than $9 billion in the fourth quarter of 2007.
Overall, bank holding companies in aggregate generated a loss of more than $8 billion during
the difficult fourth quarter of 2007.
The largest 50 bank holding companies performed better in the first quarter of 2008,
reporting profits of $5.2 billion and reduced trading losses. Consequently, bank holding
companies overall reported net income of nearly $10 billion for the quarter, down
substantially from the $36.5 billion in income they reported for the first quarter of 2007 but a
considerable improvement over the prior quarter's losses. Nonetheless, the headwinds of
heavy trading book losses proved difficult to overcome for some firms and seven of the fifty
largest bank holding companies still recorded net losses for the quarter. Moreover, as
economic conditions have softened, these large companies have reported increasing
problems in mortgage loan portfolios, particularly home equity lines of credit, and in loans to
residential real estate developers. In some cases, broker-dealer subsidiaries of bank holding
companies have suffered valuation losses on their holdings of mortgage-related assets.
Reflecting this deterioration in mortgage-related exposures, nonperforming assets more than
doubled over the past year from $37 billion to $81 billion and, as of March 31, 2008,
nonperforming assets as a share of overall assets reached the highest level since 2002.
Loan loss provisions rose sharply during the first quarter to $32 billion, exceeding net
chargeoffs by more than $14 billion, as the institutions were building their loan loss reserves in
advance of expected further deterioration in loan quality. Increased concern over the
potential for more losses from traditional lending activities has also been evident in the
Federal Reserve's Senior Loan Officer Opinion Survey on Bank Lending Practices, which in
recent quarters has shown banks tightening their lending standards and terms.
The 50 largest bank holding companies continue to work at improving their liquidity positions
in the wake of recent market turmoil. Several of these companies had brought on balance
sheet substantial assets that were originally securitized or otherwise held off balance sheet,
forcing alterations in funding strategies and increasing pressures in the term funding market.
As the Committee is aware, the Federal Reserve has taken a number of steps with its
liquidity facilities to address the difficulties in term funding markets.
In order to bolster equity positions diminished by recent writedowns, U.S. bank holding
companies - some at the urging of supervisors - have raised more than $80 billion in capital
so far in 2008. In addition, some have reduced dividends to further shore up their capital
base. Reflecting these steps, aggregate tier 1 leverage, tier 1 risk-based, and total risk-based
capital ratios for the largest 50 bank holding companies increased over the first quarter,
expanding the margins above regulatory minimums. We expect bank holding companies to
continue to report weak earnings and further asset valuation writedowns and/or significant
credit costs in coming quarters. Indeed, despite higher provisioning during the past several
quarters, coverage of nonperforming loans by loan loss reserves has not kept pace with
growth in problem assets and bank holding companies may likely face the need to further
bolster loan loss reserves. In view of this uncertain outlook, additional capital injections and
the consideration of dividend cuts are still warranted for some of these companies and we
have strongly encouraged supervised bank holding companies to enhance their capital
positions. Stronger capital positions also will allow banking institutions to participate in and
support the rebound in lending that will accompany the strengthening of the U.S. economy.
Consistent with trends in commercial banks overall, conditions at state member banks have
weakened over the past year. Problems in residential mortgage, home equity, and loans to
home builders have pushed the nonperforming assets ratio at these banks to 1.57 percent,
more than twice the level of one year ago and the highest rate since 1993. Loan loss
provisions have also accelerated, rising to a high of 1.14 percent of average loans during the
first quarter of 2008 in large part reflecting the deterioration in residential real estate-related
loan portfolios. Despite this deterioration, state member banks still reported aggregate net
income of $3.7 billion and a return on assets of about one percent for the first quarter of
2008. Moreover, more than 98 percent of these banks reported risk-based capital ratios
consistent with a "well-capitalized" designation under prompt corrective action standards.
Over the coming months, we expect banking institutions to continue to face deteriorating loan
quality. House prices are still declining sharply in many localities and losses related to
residential real estate - including loans to builders and developers - are bound to increase
further. In addition, weak economic conditions could well extend problems to other segments
of lending portfolios including consumer installment or credit card loans, as well as corporate
loan portfolios. Moreover, banking organizations must be prepared for the possibility that
liquidity conditions become tighter if uncertainties in the capital markets fail to subside or if
credit conditions deteriorate significantly. Accordingly, we anticipate that the number of banks
with less than satisfactory supervisory ratings will continue to increase from the relatively low
levels that have existed in recent years and we are monitoring developments at all
supervised institutions closely.
Risk management lessons for financial institutions
Recent market events point to a number of risk management lessons for financial institutions.
I will highlight just a few key points; many of these lessons have been documented more fully
by recent public reports and discussed in speeches by Chairman Bernanke, myself, and
other Federal Reserve officials.1
The period leading up to the recent market turbulence was an unusually good one for the
banking system, characterized by high profits, strong balance sheets, rapid innovation,
business growth, and relatively few bank failures. Unfortunately, the extended period of good
times in the banking system bred a sense of overconfidence among many bankers and other
market participants, causing them to underestimate risks and not fully consider the potential
for those good times to end. Most notably, many market participants expected housing prices
to continue their upward trend and did not properly consider what might happen if prices
leveled off or fell. In order to be good risk managers, bankers need to understand that
overconfidence and complacency must be continually battled, especially during an extended
period of good times.
Another key lesson is that if risks are to be successfully managed, they must first be properly
identified, measured and understood. Unfortunately, recent events have revealed significant
deficiencies in these areas. Notable examples are the underestimation by many firms of the
credit risk of subprime mortgages and certain tranches of structured products, as well as
poor understanding of particular market risk characteristics of structured credit products. In a
number of cases, bank managers did not exercise proper due diligence in valuing their
positions and assessing their risks, relying solely on third-party assessments of risk that
turned out to be overly optimistic. Other firms did not fully consider the linkages and
correlations between credit risk and market risk, leading to mismeasurement of their overall
exposure.
Some institutions took an excessively narrow perspective on risk with insufficient
appreciation of the need for a range of risk measures, including both quantitative and
qualitative metrics. For example, some firms placed too much emphasis on the mechanical
application of value-at-risk or similar model-based indicators. Sophisticated quantitative tools
and models play an important role in good risk management, and they will continue to do so.
But no model, regardless of sophistication, can capture all of the risks that an institution
might face. Those institutions faring better during the recent turmoil generally placed
relatively more emphasis on validation, independent review, and other controls for models
and similar quantitative techniques. They also continually refined their models and applied a
healthy dose of skepticism to model output. Stress tests and scenario analysis are tools
through which institutions can gain perspective on risks that fall outside those typically
captured by statistical models.
Another crucial lesson from recent events is that financial institutions must understand their
liquidity needs at an enterprise-wide level and be prepared for the possibility that market
liquidity may erode quickly and unexpectedly. As is now widely recognized, many
contingency funding plans did not adequately prepare for the possibility that certain
offbalance-sheet exposures might have to be brought onto the firm's balance sheet. Nor did
they adequately account for the possibility of widespread and protracted declines in asset
market liquidity. Unexpected balance sheet expansions subsequently added to funding
pressures as well as to pressures on capital ratios.
Effective oversight of an organization as a whole is one of the most fundamental
requirements of prudent risk management. Senior managers at successful firms are actively
involved in risk management, which includes determining the firm's overall risk preferences
and creating the incentives and controls to induce employees to abide by those preferences.
Often those incentives and controls must provide a counterweight to the incentives to seek
short-run profits that can be inherent in prevailing compensation practices. Strong oversight
requires access to a variety of high-quality information on a timely basis. Successful senior
managers also work to ensure that critical information is transmitted horizontally as well as
vertically; during recent events, some firms' business lines did not share vital information
relevant to risk positions and business tactics, with adverse implications for profitability.
The leaders of well-managed institutions of all sizes generally seek to have strong and
independent risk functions. Such functions support clear, dispassionate thinking about the
entire firm's risk profile. In addition, the institution benefits when senior managers encourage
risk managers to dig deep to uncover latent risks and to point out cases in which individual
business lines appear to be assuming too much risk. The lessons I just noted emphasize the
importance of risk management fundamentals, which means that they apply not only to those
institutions suffering substantial losses recently, but also to institutions faring better during
recent events.
Supervisory consideration of lessons learned
Risk management shortcomings at financial institutions highlighted by recent events also
present policy and operational challenges for supervisors. The primary responsibility for risk
management appropriately rests with the management of each institution, and our
supervisory efforts are not aiming to prevent individual banks from suffering losses, which is
part of the banking business. However, we are working to make sure that financial
institutions have a better understanding of their potential for loss and that there are not
broader breakdowns in risk management that can affect the financial system and the
economy. While events continue to unfold, some key lessons for supervisors, in addition to
bankers, are coming into focus. I would first like to highlight a few key lessons, and then in
the next section will describe corresponding supervisory actions.
For one, the increased complexity and linkage within and among increasingly globalized
markets presents greater challenges not just for bankers but also for supervisors.
Supervisors need to enhance their understanding of the direct and indirect relationships
among markets and market participants, and the associated impact on the banking system.
Supervisors must also be even more keenly aware of the manner in which those
relationships within and among markets and market participants can change over time and
how those relationships behave in times of stress - not just at banking institutions, but also at
other financial firms that play prominent roles in financial markets and whose actions and
condition can have an impact on financial stability.
Before the recent market turbulence, the Federal Reserve - in many cases along with the
other U.S. banking agencies - acted on a number of fronts to alert financial institutions about
emerging risks, for example by issuing supervisory guidance on nontraditional mortgages,
home equity lending, commercial real estate, and subprime lending. We must continue to be
vigilant about emerging risks, not just in these more turbulent times, but also when good
times return - and we must be insistent that banking organizations factor these risks into
their own risk management practices. It is also clear that supervisors need to enhance their
focus on consumer compliance issues at the point of contact between lenders and
households and on the linkages between weaknesses in consumer lending practices and
safety and soundness, such as occurred with subprime mortgages.
The current U.S. regulatory structure, with multiple supervisory agencies, has a number of
strengths and benefits, but challenges can arise in assessing risk profiles of large, complex
financial institutions operating across financial sectors, particularly given the growth in the
use of sophisticated financial products that can generate risks across various legal entities.
Congress established a consolidated supervisory framework for bank holding companies in
recognition that some risks cross legal entities and are managed on a consolidated basis.
Accordingly, monitoring those properly requires a supervisory approach directed at more
than one, or even several, of the legal entity subdivisions within the overall organization.
Recent events have highlighted the fundamental importance of enterprise-wide risk
management; both supervisors and bankers need to understand risks across a consolidated
entity and assess the risk management tools being applied across the firm.
The implementation of consolidated supervision in the United States generally works well,
with strong, cooperative relationships between the Federal Reserve and other relevant bank
supervisors and functional regulators. Information sharing among relevant supervisors and
regulators is essential to ensure that a banking organization's global activities are effectively
supervised on a consolidated basis, and we have worked over the years to develop and
enhance interagency coordination and information sharing. But as institutions grow larger
and more complex, we need to ensure that our system of consolidated supervision keeps
pace.
Supervisory actions going forward
We are acting in response to lessons from recent events to ensure the continuing safety and
soundness of the U.S. banking system. Of course, we also continue to study recent and
ongoing events to gain additional information and insights.
As a first step, supervisors are redoubling their efforts to help organizations improve their
risk-management practices, given the challenges some banks are facing today. Accordingly,
we have increased supervisory attention to this issue. For instance, supervisors are
reinforcing and strengthening their focus on assessments and testing of fundamental risk
management processes, requiring vigorous corrective action when weaknesses are
identified. We are also ensuring that institutions take a more forward-looking approach to risk
management; for example, our examiners are reviewing due diligence around commercial
real estate valuations and ensuring that bankers make appropriate adjustments based on
market conditions. This approach is consistent with recent lessons we have all learned from
residential real estate. Additionally, we are more intensely verifying assertions made by bank
management about the robustness of their risk management capabilities. Naturally, we have
focused first on the institutions in most need of improvement, but we will continue to remind
stronger institutions of the need to remain vigilant against potential weaknesses.
Supervisors are also enhancing their understanding of the full spectrum and the scale of the
risks inherent in increasingly complex banking activities and the potential for risks to
crystallize in times of stress. In particular, we are focusing on the inter-relationships among
risk types, not just with respect to those areas that precipitated recent events, but more
broadly. These forward-looking risk identification processes include a more comprehensive
understanding of institutions' main and emerging business lines and the full range of risks
they generate. We are also counseling institutions to improve their own risk identification
processes and to emphasize the importance of stress testing and scenario analyses.
Better risk management at banking organizations must be accompanied by more robust
liquidity and capital cushions. As developments of the past months clearly demonstrate, the
difficulty in identifying complexity and linkages - and their potential impact during times of
stress - requires institutions to maintain sizable and more reliable liquidity and capital
cushions, given the inherent uncertainty in financial markets. This is a key point supervisors
are reinforcing strongly.
The Federal Reserve is nearing completion of enhancements to its supervisory guidance to
clarify our role as consolidated supervisor of bank and financial holding companies - often
known as our "umbrella supervisor" role. The updated guidance is primarily intended to
provide greater clarification to our own examination staff. For example, it provides for more
consistent Federal Reserve supervisory practices and assessments across institutions with
similar activities and risks, detailing expectations for understanding and assessing primary
governance functions and risk controls, material business lines, nonbank operations, funding
and liquidity management, consumer compliance, and other key activities and risks. Again,
from a financial stability perspective the Federal Reserve has an interest not just in
identifying the risks within an individual organization, but also understanding the broader set
of risks affecting all key market participants.
The updated consolidated supervision guidance, which will be made publicly available,
naturally reiterates the importance of coordination with, and reliance on, the work of other
relevant supervisors and functional regulators. The consolidated supervision guidance under
development is being updated based on the lessons from recent events noted above. We
need to continue to work closely with other supervisors and regulators as we implement the
enhanced consolidated supervision guidance, with focus on improving interagency
coordination of supervisory activities across all bank holding companies, particularly the
largest and most complex organizations.
We are also considering new or augmented supervisory guidance on other aspects of risk
management, including further emphasis on the need for an enterprise-wide perspective
when assessing and managing risk. For example, we are developing supervisory guidance to
clarify expectations surrounding compliance risk, focusing particularly on firm-wide
compliance risk management for large, complex organizations. Another example is our
participation in the development of enhanced guidance on the management of liquidity risks,
which is being developed by the Basel Committee on Banking Supervision.
As you know, the U.S. federal banking agencies are also in the process of implementing the
Basel II framework, which is intended to enhance the quality of risk management by tying
regulatory capital more closely to institutions' underlying risks and by requiring strong internal
systems for evaluating credit and other risks. We understand that Basel II must be
implemented carefully and so have established an extended transition process with multiple
safeguards. Indeed, findings from recent supervisory reviews on the use of economic capital
have direct application to the evaluations we will make under Pillar 2, where banks are
required to have their own robust internal process to ensure that they have adequate capital
for their entire risk profile. Importantly, Pillar 2 underscores the current supervisory authority
to require institutions to hold additional capital if the agencies are not satisfied with the levels
chosen by bank management. We are also working with the Basel Committee to ensure that
the Basel II framework appropriately reflects the lessons of recent events, such as by
strengthening the capital treatment of off-balance-sheet vehicles and assessing the use of
external credit ratings to determine capital charges.
Conclusion
The Federal Reserve plays an important role in the strong supervisory structure we have
here in the United States. And we are committed to making our supervisory and regulatory
processes as strong as possible, improving them when necessary. Going forward, we must
continue to send strong supervisory messages to senior management at financial institutions
- perhaps with more force and frequency than in the recent past - particularly since during
extended periods of good times institutions can lose their focus on the importance of sound
risk management fundamentals. We continue to review our supervision practices to identify
and act on potential areas for improvement in light of recent events.