Donald L Kohn: Restoring financial intermediation by banks - the role of
regulators
Speech by Mr Donald L Kohn, Vice Chairman of the Board of Governors of the US Federal
Reserve System, at the Office of Thrift Supervision National Housing Forum, Washington
DC, 8 December 2008.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
I thought I might use these brief introductory remarks to put some of our challenges as
regulators in the broad context of the tremendous shifts in the pattern of financial flows that
we are witnessing. Traditionally, funds have been channeled from savers to borrowers in two
ways: through financial markets and through financial intermediaries, such as banks and
savings institutions. The turmoil in the U.S. financial system during the past 16 months has
put both channels of financial intermediation under great strain and, in doing so, has
produced a significant financial crisis. Large losses taken by financial institutions and
investors, mostly from mortgage-related assets, have increased uncertainty and undermined
confidence; these events have caused lenders to greatly tighten credit conditions for
households and businesses, which, in turn, have contributed to a downturn in the economy
that has reinforced the strains in the financial system.1
One consequence of the distress in financial markets is that banks are being pushed to take
a greater role in financial intermediation, which reverses, in part, a long-term trend away from
bank-based financial intermediation and toward market-based intermediation. And, indeed,
bank lending surged earlier in the fall following a lull over the summer. However, the degree
to which the pickup represented deliberate choices by banks is unclear, as many households
and businesses reportedly drew on previously committed lines of credit, and selling of loans
in securitization markets was hampered by further deterioration in those markets. In recent
weeks, bank lending appears to have dropped back, consistent with the significant tightening
of terms and standards reported by bank loan officers in recent quarters as well as the
weakening of economic activity.
The need for greater bank intermediation has occurred at a time when banks are managing
losses and are worried about meeting their funding needs. Concerns about banks'
creditworthiness have made it costly for them to issue long-term debt. Growth in bank
deposits has been fairly strong this year, and the recognition that deposits can be a reliable
source of funds protected by the federal safety net has perhaps helped to draw investment
banks to convert to bank holding companies. But the competition for deposits has raised their
relative cost, and deposits cannot be expected to make up fully for reduced funding from
other sources.
The challenge for regulators and other authorities is to create an environment that supports
greater bank intermediation, which should help to restore the health of the financial system
and the economy. We want banks to be willing to deploy capital and liquidity, but they must
do so in a responsible way that avoids past mistakes and does not create new ones.
Banks need access to funds to make loans - especially with securitzation markets impaired
- and the authorities have taken several steps to enhance the supply of funds to banks. The
Treasury, working with the regulators, has used its authority under the Emergency Economic
Stabilization Act, or EESA, to inject capital into banks so they will be stronger and more
stable. The Federal Deposit Insurance Corporation has expanded its guarantee on deposits
and is insuring new senior debt obligations of banking firms. The Federal Reserve has
reduced the cost of borrowing at the discount window and created a new facility to provide
term credit to banks.
The Federal Reserve and the other federal banking agencies have also issued regulatory
guidance to promote greater lending by banks. This guidance encouraged banks to meet the
needs of creditworthy borrowers in a manner consistent with safety and soundness -
specifically, by taking a balanced approach in assessing borrowers' ability to repay and
making realistic assessments of collateral valuations.2 Additional capital, liquidity backstops,
and regulatory encouragement should all reinforce financial stability and set the stage for
increased bank lending.
As it is neither realistic nor desirable for banks to meet all financial intermediation needs, the
Federal Reserve and other authorities are also making efforts to stabilize financial markets
more broadly. In this regard, the Federal Reserve has created facilities to lend to primary
dealers, to purchase highly rated commercial paper at a term of three months, and to provide
backup liquidity for money market mutual funds. We are also creating a facility to support the
issuance of asset-backed securities collateralized by student loans, auto loans, credit card
loans, and loans guaranteed by the Small Business Administration.
In related actions, policymakers are taking steps to address the problems in housing and
mortgage markets. The Federal Reserve supported placing Fannie Mae and Freddie Mac
into conservatorship to help stabilize an important source of housing finance. More recently,
the Federal Reserve has announced that it will purchase $600billion in debt issued by the
housing-related government-sponsored enterprises and in mortgage-backed securities
backed by Fannie Mae, Freddie Mac, and Ginnie Mae, which could reduce funding costs for
mortgages. It also is supporting foreclosure prevention and neighborhood stabilization
efforts, which help reduce unnecessary foreclosures and their costs on communities. Limiting
foreclosures will also help reduce the risk that house prices will sink significantly below the
level justified by fundamentals.
The events of the past year and a half have highlighted the need for changes in our financial
system. Presumably, such changes may include a different balance between bank-based
and market-based financial intermediation. As regulators of banks and thrifts, our job is not to
determine what this balance should be. Rather, our job is, and has been, to create an
environment in which, in the short run, banks can step up to fill as much of the gap as
possible that has been left by still-dysfunctional markets, consistent with a strong, stable
banking system. Over time, of course, we will need to work with the Congress and the new
Administration to construct a system of oversight over both markets and institutions that
better protects the stability of the financial system and the U.S. economy.