Donald L Kohn: Risk management and its implications for systemic risk
Testimony of Mr Donald L Kohn, Vice Chairman of the Board of Governors of the US Federal
Reserve System, before the Subcommittee on Securities, Insurance, and Investment,
Committee on Banking, Housing, and Urban Affairs, US Senate, Washington DC,
19 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 Reed, Ranking Member Allard and members of the Subcommittee, it is my
pleasure to appear today to discuss several issues related to the oversight of financial
institutions. First, I will discuss the circumstances leading to the establishment of our
temporary facility for lending to primary securities dealers and our arrangements for
monitoring their financial condition. Then, I will describe Federal Reserve activities related to
the banking institutions we supervise, including concrete steps to address identified issues
and to help these institutions improve risk management practices. Finally, I will briefly
summarize planned enhancements to our consolidated supervision of bank and financial
holding companies.
Federal Reserve monitoring activities related to the Primary Dealer Credit Facility
Three months ago, the Board approved the establishment of the Primary Dealer Credit
Facility (PDCF). This action was taken pursuant to Section 13(3) of the Federal Reserve Act,
which empowers the Board of Governors to authorize a Federal Reserve Bank to lend to a
corporation, including a securities firm, in "unusual and exigent" circumstances when the
corporation cannot "secure adequate credit accommodations from other banking institutions."
In doing so, the Board of Governors made the necessary statutory finding that market
circumstances were indeed unusual and exigent. We judged that without increased access to
Federal Reserve liquidity by major securities firms, overall financial market conditions would
have deteriorated further and would have had a substantially adverse effect on the economy.
We fully recognized that the use of this legal authority was an extraordinary step, but
considered it necessary given the circumstances. To quickly design and implement a facility
to provide this liquidity, we made use of existing business relationships with a group of 20
securities firms, known as primary dealers. The Open Market Desk of the Federal Reserve
Bank of New York trades U.S. government securities with primary dealers to implement
monetary policy on behalf of the Federal Reserve System. The PDCF makes available
overnight funding to sound primary dealers in the form of loans secured by collateral eligible
to be pledged in open market operations, plus investment-grade corporate, municipal, and
mortgage-backed and asset-backed securities. The PDCF was authorized for a minimum
period of six months.
Most of the primary dealers are owned by either U.S. or foreign banking organizations that
have been approved as U.S. financial holding companies. The U.S. financial holding
companies owning primary dealers are subject to consolidated supervision by the Federal
Reserve, but for the primary dealers within financial holding companies we rely extensively
on the Securities and Exchange Commission (SEC) as functional regulator. The SEC, rather
than the Federal Reserve, serves as consolidated supervisor for the major U.S. investment
banks with primary dealers. In connection with the establishment of the PDCF, we created a
program to monitor the financial and funding positions of primary dealers, focusing on those
primary dealers not owned by financial holding companies. From the beginning, we have
coordinated closely with the SEC, and we are currently working on an agreement with that
agency to enhance information sharing both for primary dealers that are part of financial
holding companies and for those that are not.
The objectives of our PDCF monitoring program are: (1) to establish the basis for an
informed judgment by the Federal Reserve of the liquidity and capital positions of the primary
dealers accessing the PDCF; and (2) to minimize the risk that the availability of financing
under the PDCF undermines the incentives for the consolidated entity to manage capital and
liquidity to levels appropriate for a sustained period of market disruption.
The Federal Reserve's monitoring program for primary dealers includes a limited on-site
presence at the four largest investment banks and has a narrower focus than our broader
supervision and examination of state member banks, bank holding companies, and the U.S.
operations of foreign banking organizations. Specifically, the Federal Reserve is not
supervising investment firms comprehensively to assess risk management. Rather, our
purpose is specifically to assess the adequacy of liquidity and capital.
To support our monitoring efforts, which are closely coordinated with the SEC, we receive
internal information from the firms on a daily basis that enables us to identify changes in the
level and composition of the firms' holdings of cash and unencumbered, highly liquid assets.
We also receive qualitative information regarding the posture of counterparties and clients
toward the firms, including the extent, if any, to which the firms are encountering difficulty in
rolling over secured and unsecured funding. In addition, along with the SEC, we are
assessing the firms' current and planned capital positions in light of their near-term earnings
prospects. In both of these areas - liquidity and capital - we are evaluating the firms' efforts
and, with the SEC, providing feedback to their senior management teams.
Broadly speaking, we believe that primary dealers are strengthening liquidity and capital
positions to better protect themselves against extreme events. We also believe their
management has learned some valuable lessons from the events of the recent financial
turmoil that should translate into better risk management. We continue to monitor the effect
of the PDCF and are studying a range of options going forward.
Federal Reserve supervisory activities
I would now like to discuss the Federal Reserve's recent activities relating to banking
institutions we supervise. As I noted in testimony before the full Committee on June 5, recent
events have highlighted a number of risk management lessons for banking organizations,
many of which have been documented in recent public reports.1 In that testimony, I outlined
the Federal Reserve's broad supervisory responses to recent events, which include requiring
banking institutions to improve risk management, augmenting existing supervisory guidance,
and where necessary, enhancing our own supervisory processes.
Naturally, the risk management lessons from recent events vary by institution, since the
types of deficiencies differed and some institutions fared better than others. Thus, in our
supervisory efforts, we are taking these broad lessons and applying them to each institution
as needed. But we can point to some general areas where we are focusing supervisory
attention and encouraging better risk management at banking institutions. For one,
supervisors are reinforcing and strengthening their assessments and testing of fundamental
risk management processes, requiring vigorous corrective action when weaknesses are
identified. We are ensuring that institutions take a more comprehensive and forward-looking
approach to risk management across the entire firm, and are more intensely verifying
assertions made by bank management about the robustness of their risk management
capabilities.
Supervisors are also ensuring that banks understand the full spectrum and the scale of the
risks inherent in increasingly complex banking activities and the potential for their risks to
crystallize in times of stress. In particular, banks must focus on the inter-relationships among
risk types, not just with respect to those areas that precipitated recent events, but more
broadly.
In light of recent events, we have redoubled our efforts to ensure that senior management
properly defines overall risk preferences and creates incentives for employees to abide by
those preferences, such as effective firm-wide limits and controls. We are reminding banks of
the importance of information-sharing throughout the entire organization and of the dangers
of information silos. In addition, we are strongly encouraging institutions to improve and/or
build out their risk functions, so that independent risk managers are empowered to dig deep
for latent risks, including concentrations that often arise only in times of stress.
Having given some general thoughts on current supervisory issues and supervisory
approaches to improving risk management, I would now like to turn to a few specific areas in
which we are addressing the challenges facing institutions and helping bring about
improvements in their risk management.
Residential lending
Risks associated with residential mortgage and home equity lending remain a top
supervisory priority due to the continued negative trends in home prices, elevated levels of
delinquencies and foreclosures, and slack demand for residential mortgage securities in the
secondary markets. Banks continue to experience losses on residential first mortgage loans,
especially, but not exclusively, on nonprime lending. Losses on home equity loans are also
increasing significantly, even for lenders not heavily involved in subprime lending, and loss
severities as a percentage of outstanding exposure on this product are greater than for first
lien loans. And mortgage securities markets whose instruments are not supported by
government-sponsored entities continue to be adversely affected by problems in the housing
market, complicating banks' risk management in this sector.
Supervisors are acting on several fronts to address problems related to residential first and
second mortgages. First, we are making sure institutions comply with our existing guidance
on nontraditional mortgages and on home equity loans, issued in 2006 and 2005,
respectively, as well as guidance on subprime lending issued last year. And we are
evaluating institutions based on the risk management practices discussed in those guidance
documents. We expect institutions to conduct rigorous stress tests of potential future losses
related to residential mortgage loans, home equity lines, and mortgage-backed securities.
We continue to encourage lenders and mortgage servicers to work constructively with
borrowers at risk of default and to consider prudent workout arrangements to avoid
unnecessary foreclosures. As you know, the Federal Reserve believes that prudent workout
arrangements that are consistent with safe and sound lending practices are generally in the
long-term best interest of both the financial institution and the borrower.
Furthermore, we are working to finalize the proposed amendments to the rules under the
Home Ownership and Equity Protection Act that we proposed in December. The proposed
amendments, which would apply to all creditors, would better protect consumers from a
range of unfair or deceptive mortgage lending and advertising practices that have been the
source of considerable concern and criticism. Our proposal includes key protections for
higher-priced mortgage loans secured by a consumer's principal dwelling and addresses
concerns about a lender's assessment of a borrower's ability to make the scheduled
payments, including verification of the consumer's income and assets. The proposal also
addresses concerns about prepayment penalties and the adverse impact on consumers of
lenders failing to escrow for taxes and insurance. Protecting consumers also has benefits for
lenders because it should reduce delinquencies and defaults that can occur when consumers
do not understand or cannot afford certain types of loans. We are working toward issuing
final regulations in July.
Commercial real estate lending
Commercial real estate (CRE) lending is another area that requires close supervisory
attention. In 2006, well before CRE markets began to soften, property values began to level
off or decline in certain markets, and fundamentals began to turn somewhat negative, the
Federal Reserve and other banking agencies issued guidance on CRE concentrations. We
were concerned that the increasing concentrations of CRE loans in the portfolios of many
banks, especially small and medium-sized lenders, made them more vulnerable to a
softening in this market if the risks were not well managed. Since then, delinquencies on
construction loans have begun to rise, particularly for residential construction loans, and they
are expected to rise further. Those institutions with high CRE concentrations in geographic
areas suffering real estate pressures will likely bear losses. Further, the significant slowdown
in the origination of commercial mortgage-backed securities will reduce banks' options to
manage CRE portfolio risks through the secondary market.
As I noted in my March testimony on the condition of the U.S. banking industry, we have
been stepping up our reviews of state member banks and bank holding companies exhibiting
concentrations in CRE, especially in those areas of the country exhibiting signs of weakness.
We continue to monitor banks' adherence to the supervisory guidance I just noted. These
efforts include monitoring carefully the potential impact of lower valuations on CRE
exposures. Through those reviews, we are identifying weaknesses in banks' risk
management practices, including underwriting practices, appraisal processes, stress testing,
and market analysis. Based on these results, we are updating our supervisory plans and
examination schedules to focus our resources most effectively on those institutions
presenting the greatest risk and needing the most improvement. Finally, we just concluded a
Federal Reserve examiner training effort on CRE topics, including appraisal practices, loan
loss allowances, stress testing, and board and management oversight. The training focused
on the importance of ensuring prudent risk management practices, without unduly curtailing
credit availability.
Counterparty credit risk
Concerns in financial markets about the creditworthiness of some financial intermediaries
have eased somewhat since the first half of March, but those concerns remain relatively
high. More fundamentally, the proper management of counterparty credit risk - which is the
risk of loss from a counterparty's failure to perform its financial obligations - is a prerequisite
for protecting the entire system from contagion when any one institution fails.
Consistent with the recommendations of recent reports, we are looking at how firms are
addressing weaknesses in counterparty credit risk management practices highlighted by
recent events, including the measurement and aggregation of exposures stemming from a
wide range of transactions with both unregulated and regulated entities. For instance, we are
emphasizing that firms should use a variety of techniques to measure potential exposure on
over-the-counter (OTC) derivatives, repurchase agreements, and other contracts, and that
they should aggregate all exposures to each counterparty. In this context, we have been
closely monitoring counterparty exposures arising from transactions with monoline financial
guarantors and have been discussing with banks the measurement and management of
these positions.
In addition, we are working to strengthen the market infrastructure for financial transactions
to make it more robust and more resilient. In particular, the Federal Reserve Bank of New
York continues to work with domestic and international prudential supervisors of OTC
derivatives dealers to strengthen the infrastructure for those large and rapidly growing
markets. The supervisors are emphasizing to the major dealers and to other active market
participants the importance of setting standards for the accuracy and timeliness of trade data
submission and for the timeliness of resolutions of errors in trade matching for OTC
derivatives contracts. Furthermore, consistent with the recommendations made in recent
reports on turbulence in financial markets, supervisors are encouraging the development by
the industry of a longer-term plan for an integrated operational infrastructure supporting OTC
derivatives that captures all significant processing events over the entire lifecycle of trades,
delivers operational reliability, and maximizes the efficiencies obtainable from automation
and electronic processing platforms. In addition to supporting more robust exposure
measurement and capture, these enhancements should strengthen participants' ability to
manage counterparty risk through loss mitigation techniques such as the use of netting and
collateral agreements. We are encouraged by recent industry efforts to address counterparty
credit risk, such as plans to extend central counterparty clearinghouse services to credit
derivatives and other initiatives.
Credit cards
Credit card charge-offs have continued to rise over the past several quarters, although
charge-offs remain well below their early 2002 peak. Not surprisingly, some banks report that
delinquency rates for unsecured consumer debt are generally higher in areas that have
experienced significant home price depreciation and increased unemployment. In response
to these trends, many issuers are tightening credit standards and reducing exposures in
these higher risk markets. Rising delinquencies and increased card usage that has been
reported in recent months are likely to push charge-off levels higher in future quarters.
Therefore, we will continue to monitor credit card markets and other consumer lending
sectors for potential weaknesses.
The Federal Reserve has also taken steps toward improving consumer protection for credit
card users. Our first step was the Board's 2007 proposal to substantially revise and improve
credit card disclosures under the Truth in Lending Act. In preparing this proposal, we
conducted extensive consumer testing to determine the type and format of information that
consumers find most useful in shopping for and choosing a credit card. This extensive
consumer testing - and the thousands of public comments on our proposal - suggested that
disclosures may not provide sufficient consumer protection with regard to certain practices.
Therefore, we recently proposed rules under the Federal Trade Commission Act to protect
consumers from financial harm caused by those practices. If implemented, the proposed
rules would require financial institutions to make changes to their business models and to
alter some practices. The Federal Reserve developed this proposal jointly with the Office of
Thrift Supervision and the National Credit Union Administration. We are continuing to use
consumer testing as we work toward issuing final rules for credit cards by year-end.
Commercial lending
Commercial lending activity, aside from a few sectors such as leveraged lending, has not
been markedly affected by the recent volatility in the financial markets, but may encounter
more difficulty should slow economic growth persist. Lenders and investors are demanding
stricter underwriting standards and higher returns for commercial loans. With regard to the
condition of existing commercial loan portfolios, delinquencies have been rising recently as
has the volume of criticized assets. This has been most evident in the leveraged loan market,
where lending standards appeared to weaken noticeably in recent years, and which tends to
be more susceptible to soft economic conditions.
Supervisors are monitoring banks' commercial lending activities, particularly leveraged loan
portfolios, to detect weaknesses in asset quality that may result from slowing economic
conditions and to ensure appropriate risk management practices. In part, the agencies rely
on their Shared National Credit (SNC) program to assess the credit quality of banks'
commercial loan portfolios. The 2008 review is now underway and will provide additional
insight into the condition of large syndicated credits that are shared by three or more banks,
including an evaluation of underwriting practices and trends in the leveraged loan market and
the broader syndicated loan market.
Adequacy of loan loss allowance
As the banking system has faced a more difficult environment in recent quarters, our
examiners have identified significant weaknesses at some institutions in identifying and
reserving against problem loans, which in some cases have led to deficiencies in allowance
levels at some supervised institutions. In response, our examiners continue to remind
bankers that allowance levels should be reflective of loan portfolio quality, based on sound
processes, and consistent with current supervisory guidance. We recently provided
additional clarity to our examiners regarding existing interagency guidance on loan loss
allowances that should be factored into current examinations and inspections of state
member banks, bank holding companies, and their nonbank subsidiaries. We believe this
further clarity to our examination staff will help them in their regular discussions with bankers
to ensure that reserving practices are robust and loan loss allowances are indeed adequate
to the circumstances facing each institution.
Liquidity risk management
Recent reports cite the need for enhancement to liquidity risk management as one of the key
lessons from recent events. Financial institutions must understand their liquidity needs at
both the legal entity and enterprise-wide level and be prepared for the possibility that market
liquidity may erode quickly, unexpectedly, and for a protracted time. As is now widely
recognized, many contingency funding plans did not adequately prepare for the possibility
that certain off-balance-sheet exposures might have to be brought onto the firm's balance
sheet, calling on available liquidity. Nor did they adequately account for the possibility of
widespread and protracted declines in asset market liquidity. While liquidity pressures in
banking and financial markets have eased of late, we do recognize that institutions must
prepare themselves for the possibility that liquidity problems could return, either market-wide
or at an individual institution.
Supervisors are working with institutions to improve liquidity risk management practices. For
instance, we are reviewing banks' contingent funding needs and sources of funding. We are
ensuring that bankers develop appropriate short-term and long-term liquidity risk
management strategies. Consistent with the findings of recent reports, we are emphasizing
the importance of appropriate stress testing of liquidity needs and maintenance of robust
liquidity buffers. In addition, we worked with our colleagues on the Basel Committee on
Banking Supervision to enhance existing guidance on the management of liquidity risks,
which was released two days ago. That work was drawn from recent and ongoing efforts on
liquidity risk by the public and private sectors and is intended to strengthen banks' liquidity
risk management and improve global supervisory practices. Of course, the Federal Reserve
has undertaken a number of programs to bolster market liquidity.
Capital needs
Clearly, capital is a critical defense against unexpected losses. Even with the recent turmoil,
the U.S. banking system remains well capitalized. However, as I noted in my June 5
testimony, we are encouraging institutions to raise capital as needed, in part so that they will
be well positioned to take advantage of future opportunities and to support a strengthening of
financial conditions and a rebound in economic growth. And the recent capital injections into
banking organizations and other financial institutions are a good sign that investors see value
in those institutions and in the banking industry as a whole.
To assess the sufficiency of firms' capacity to absorb unexpected losses from a wide range
of sources, Federal Reserve supervisors have heightened their review of capital analysis and
forecasting at banking organizations. Examiners are reviewing the reasonableness of
assumptions banking organizations use to assess capital needs and are emphasizing
forward-looking analysis. For example, we are evaluating banks' use of stress scenarios to
see if they adequately incorporate a range of possible events and properly identify potential
capital needs and capacity across the firms. The scenarios address a number of possible
factors including unexpected balance sheet expansion, earnings deterioration across key
business lines, and stress-level losses generated by a variety of positions and multiple
sources.
In addition, last year the Federal Reserve conducted a review across a number of large
banking organizations to assess these firms' use of so-called "economic capital" practices,
which are a means for firms to calculate, for internal purposes, their capital needs given their
risk profile. Consistent with other findings, we found that some banks relied too extensively
on the output of internal models, not viewing model output with appropriate skepticism.
Models are dependent on the data used to construct them. When data histories are short or
are drawn mostly from periods of benign economic conditions, model results may not be fully
applicable to an institution's risk profile. We concluded that banks would generally benefit
from better evaluation of inputs used in their internal capital models, stronger validation of
their models, and broader use of stress testing and scenario analysis to supplement the
inherent limitations of their models. We are incorporating the results of this horizontal review
in our current assessments of banks' overall capital adequacy, as well as using it to evaluate
banks' readiness to meet the requirement in Pillar 2 of Basel II that banks develop their own
internal process to assess overall capital adequacy, beyond regulatory capital measures.
Consolidated supervision program
The supervisory activities just described are intended to address many of the risk
management lapses seen over the past year, some of which pertain to shortcomings in
firmwide risk identification and measurement. Consistent with our regular efforts to improve
supervisory practices, we realize that our program of consolidated supervision could be
enhanced and made more systematic. Supervising a consolidated banking organization
requires review of all risks on an enterprise-wide basis, not just review of the risks contained
in each subsidiary legal entity. To this end, 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.
The updated consolidated supervision guidance, which will be publicly available, is primarily
intended to provide greater clarity 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.
In this sense the forthcoming guidance is very consistent with the Federal Reserve
supervisory actions I have just described. The enhanced guidance will help us better identify
and address firm-wide issues at supervised banking organizations, while also promoting
better risk management.
I want to make clear that consolidated supervision of bank and financial holding companies
in the United States generally works well, with strong, cooperative relationships between the
Federal Reserve and other relevant bank supervisors and functional regulators. Indeed,
much of the supervisory work I just described is being done in cooperation with primary
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.
Finally, it is worth noting that the Federal Reserve's umbrella supervision role closely
complements our other central bank responsibilities, including the objectives of fostering
financial stability and deterring or managing financial crises. The information, expertise, and
powers derived from our supervisory authority enhances the Federal Reserve's ability to help
prevent financial crises, and to manage such crises should they occur, working with the
Treasury Department and other U.S. and foreign authorities. In this manner, enhancements
to our consolidated supervision program, which include close coordination with primary
supervisors and functional regulators, should provide broad benefits for the financial system
and the economy.