Presentation to the Western Independent Bankers Association
By Janet L. Yellen, President and CEO of the Federal Reserve Bank
For delivery March 14, 2005, 8:30 AM Hawaii Time, 1:30 AM Eastern
Thoughts on the Economy and the Banking Sector
Thank you, John, for that kind introduction.
to be with you today. As John said, I’m new to the San Francisco
Fed. I’m still in my first year as President. But I’m not
new to the Federal Reserve System. Nor am I completely new to banking
issues. When I was a Governor at the Board some ten years ago, I served
on the Committee on Markets and Regulation, where we focused on risk
management and systemic risk, including supervising risk-taking at banks.
period—the mid-1990s—was a fascinating time to work on
banking issues. With the industry getting back on its feet after the
dismal days of the early
part of the decade, there was renewed energy for change. The legislative groundwork
for Gramm-Leach-Bliley was being laid. Consolidation and expansion of interstate
banking were moving ahead. Securitization was having a profound impact on the
role of banks in funding credit. In derivatives markets, large banking organizations
were both users and market makers.
Today, ten years later, these trends are
still changing banking. The challenge for the Fed and the other agencies
has been to figure out the appropriate responses
of bank supervision and capital regulation. For example, with banks competing
in the broader financial services arena, it has been important in adapting
supervision and regulation to limit the attendant burdens on banks. Indeed,
when I was at
the Board, one of the first things I learned—in a very graphic way—is just
how heavily regulated the banking industry is. Here’s what happened.
When I first joined the committee, I wanted to get up to speed on the issues,
asked for a copy of the Fed’s regulations to review. What I expected was a couple of thick binders. What I got was something else altogether.
research assistant came into my office rolling what looked like a grocery
store shopping cart, and it was filled with volumes of regulations!
to say, that image has stuck with me, and it has made me very supportive
of efforts to reduce those regulatory burdens wherever feasible. At the
same time, there are clear public policy concerns that justify bank supervision
of risk and capital regulation. For example, even with all the changes
banking, the potential for moral hazard that’s related to the federal
safety net for banks remains a concern. In addition, supervision addresses
systemic risk—something that banks don’t fully factor into
their own risk-management decisions. That’s why it makes sense for
bank supervisors to have a role in ensuring that banks make careful and
about the degree of risk they bear and hold capital commensurate with that
In my remarks today, I want to start by exploring
a key construct underpinning the changes in supervision and regulation
of risk that has
them less intrusive to the operations of banking. I’ll argue that
the advances in risk management at banks and the changes in the supervision
and regulation of
banks have occurred through a mutually reinforcing process—where sometimes
the private sector has taken the lead, and sometimes regulation and supervision
helped push risk management forward. Then I’ll turn to the impact
of the economy on banking in recent years. I’ll conclude with some
issues that are on our supervisory radar screen.
Supervision, Regulation, and Risk Management in Banking
The idea that advances in risk management at
banks and changes in capital regulation and risk supervision can be mutually
reinforcing processes is not terribly
surprising. Although banks and bank supervisors have different motives—which
certainly can lead to differing views about what the appropriate level of
risk is—they also have a common interest in having accurate measures
of risk and in focusing on the processes and techniques for managing risk.
banks, good risk management is key to creating value for shareholders—that
is, profits. For bank supervisors, good risk management and capital regulation
are key to ensuring the safety and soundness of the banking system.
example of how this common interest led to the mutually reinforcing process
is the focus on capital as a fundamental part of risk management. In
the early 1980s, bank supervisors had good reason to be concerned about banks’ declining
capital positions. They took the initiative by instituting explicit capital
requirements. Then came the first Basel Accord, which took effect in the
early 1990s. It broke new ground by tying the level of capital to the riskiness
assets. Admittedly, this risk-based framework was crude, but it was a start.
More importantly, though, Basel I was about increasing capital in banking
and putting capital on the front line in risk management, both for supervisors
and for banks.
Basel I did succeed in increasing capital in banking. Today,
ninety-seven percent of U.S. banks are considered not just adequately capitalized,
well capitalized, and the average risk-based total capital ratio sits at
close to thirteen percent. Market capitalization ratios for many banking
are even more impressive.
Despite this success in raising capital ratios,
it was apparent early on that the first Basel Accord’s approach
had flaws, especially for large, complex banking organizations. One
serious concern was that some institutions
able to use securitization to reduce their funding requirements without
commensurately reducing their risk. While the regulators were able
to come up with ways
to set capital requirements for such retained risk, it was a bit like writing
software patches for an out-of-date operating system. By the mid-1990s,
it was clear that we needed a new operating system.
The path to the new system,
Basel II, provides another illustration of the
mutually reinforcing process. This time, the innovations originated not
with the supervisors, but with the bankers. They had developed models
their processes, procedures, and techniques, including statistical models
for assessing portfolio risk. Regulators saw that these "state of
the art" risk-management
tools also provided the makings of a framework that they themselves could
use to address the shortfalls of Basel I. Clearly, leveraging the risk-management
techniques banks were already using represented a significant intellectual
step forward in bank supervision.
I realize that when it comes to Basel
II, some of you may be thinking, “Why
should I care about that?” After all, in the United States, only
about ten large, complex, internationally active banks will be required
to use internal
risk models to determine their capital requirements, and another ten
or so may qualify to opt-in to do so. But even if you’re not among
those 20 or so institutions, my answer still would be that, indeed, you
and be knowledgeable about Basel II—perhaps not in terms of the
detail, but in terms of the risk-management principles underlying the
principles are: striving to assess your overall portfolio risk and having
confidence in the reliability of your risk assessment process.
goal is actually one that supervision helped to push forward long before
Basel II. Ten years ago, when I was at the Board of Governors,
rolled out our “risk-focused supervision.” Since then,
although we still engage in so-called transactions testing, we have
assessing internal systems and controls for evaluating and managing
risk. I think this approach has been effective and that it has helped
risk management in the banking industry.
The economy and banking
As I’ve described, risk management at banks
and bank supervision were moving in the right direction in the second
half of the 1990s. But the industry
had yet to be tested by adverse economic shocks. Well, beginning in 2000, we
started to get those shocks: the dot-com bust, the investment bust, then 9/11,
the wars in Afghanistan and Iraq, and the corporate governance scandals. Not
surprisingly, these shocks led to serious erosion in confidence and a pullback
in spending by the business sector.
Both monetary policy and fiscal policy
responded aggressively to these shocks. The Fed slashed short-term interest
rates starting in 2001 to their lowest
levels in forty years. And the Congress passed tax-cut packages to stimulate
spending. But because these macro policies, especially monetary policy, affect
the economy with a lag, we still had substantial job losses and clear signs
of stress in the corporate sector. For example, bond downgrades and defaults
rose sharply in the recession, matching levels reached in the previous recession.
And risk spreads on high-risk corporate bonds spiked, exceeding previous
the face of these shocks, both large banks and community banks proved to
be far more resilient than in the previous recession. And it would appear
the developments I’ve been discussing—stronger capital positions in
conjunction with improvements in supervision and banks’ advances in
risk-management—deserve much of the credit for this resilience. For
example, in terms of bank supervision,
research indicates that supervisory ratings were stiffer for a given set
of performance measures going into the last recession than they were earlier
the 1990s. This is consistent with the shift to risk-focused supervision
that I mentioned earlier.
In terms of good management, it appears that, even
where there were potential
risk exposures, banks took relatively safe positions. That is illustrated
in the experience with syndicated loans, where the data show increases
over the cycle, but with non-banks holding more of the riskier loans than
banks. Prudence on the part of banks clearly came into play in other respects,
well. Federal Reserve surveys show that banks tightened credit standards
and required that loans have lower loan-to-value ratios before the downturn,
our examiners have confirmed that during on-site reviews.
Before we pat
ourselves on the back for such great supervision and such great management,
let me point out that some things about the economic
itself turned out to be favorable for the banking industry in this cycle.
For one thing, banks were less exposed to the sectors under the most
as telecommunications and energy. Probably the most significant favorable
factor was the remarkable strength of consumer spending, especially on
housing, which was spurred in part by the low interest rate environment.
This gave a boost to bank earnings through growth in lending, especially
refinancing. Also, commercial real estate loan quality at banks held
up relatively well, even with the rise in vacancies and declines in rents,
in part because
of the decline in mortgage rates and the rise in refinancing that lowered
debt burdens for businesses.
The economic environment during the current
cycle also affected the makeup of bank portfolios. With low interest
rates and high profits in the recovery,
nonfinancial businesses restructured their balance sheets. They moved
to longer-term financing and also tapped internal funding. For large
this meant a sharp
decline in C&I loans and credit enhancements on commercial paper—though
they have shared in the rise in bond underwriting. For community banks
the restructuring meant a slowdown in C&I lending, though business
loan growth was still positive.
The restructuring by businesses also
reinforced the growth in commercial real estate lending at banks, including
community banks. Here in the
West, the share
of commercial real estate loans for banks with under one billion dollars
in assets exceeds the national average of twenty-eight percent in most
states. Concentration is especially high in California, where commercial
loans account for forty-six percent of loans among community banks.
As you know, when residential mortgages are
added, total real estate loans account for the lion’s share of the lending among community
banks. The average share for the West as a whole is about the same as
for the nation—at
seventy percent—with Hawaii at the top with seventy-eight percent,
followed by California with seventy-seven percent.
This emphasis on real estate financing by banks is understandable,
given developments in credit markets. First, residential real estate
to the economy
has grown substantially. Even with securitization, it is not surprising
that banks would share in the growth, especially given the decline
in the role
of savings institutions. Also, banks as intermediaries have a comparative
in funding more idiosyncratic credit, such as commercial real estate.
The commercial real estate mortgage-backed securities market is
not fast enough
to absorb the overall rise in commercial real estate credit. The
bottom line is that among community banks there is a notable degree
and the trend has been toward more concentration.
Outlook for the economy and banks
That brings me to the outlook. After the economic
expansion stumbled in the spring of last year, it now looks to be on
a firmer footing. A broad range
of economic data suggests that real GDP is growing noticeably above trend.
By most estimates, trend is around three and a quarter to three and a half
percent. We’ve seen vigorous growth in business spending and solid
growth in consumer spending. Employment hasn’t been quite as strong
as expected, especially given all the monetary and fiscal stimulus out there.
Even so, the economy generated an average of nearly 200,000 new jobs a month
over the past twelve months.
As the economic expansion has firmed over the
past few months, the Fed has removed some degree of accommodation, bringing
the fed funds rate to two and
a half percent. In its recent statements, the FOMC has indicated that the
expansion seems likely to remain on track, with inflation pressures remaining
So long as this scenario holds up, the Committee has said that it expects
to continue to remove the policy accommodation at a pace “that
is likely to be measured.”
At banks, the renewal of strong growth
in C&I lending in recent months
is consistent with the rise in business investment. We will probably see
business demand for credit rise further with the trimming of profit
growth among nonfinancial
firms. The repatriation of profits from abroad this year, however, could
affect businesses’ demand for credit, at least at the larger
banks. Nevertheless, in terms of the ability to borrow, business balance
overall look to
be in good shape in terms of debt burdens.
When it comes to households,
we don’t know for sure what levels of debt
burden they feel comfortable with. Although the Federal Reserve’s
figures on financial obligations relative to income for households have
come down some
in recent quarters, they are still high. Nonetheless, the expectation
is that consumer spending will continue to grow at a moderate pace.
banks, an expanding economy should support loan growth and good asset
quality. But there are some areas for caution in the banking outlook,
and that brings
me to what’s on our supervisory radar screen at the San Francisco
Supervisory radar screen
I already mentioned growing commercial real
estate concentrations. That’s
been prominent on our radar screen for some time because concentrations
are especially high at western banks. Earlier this year, exam staff
at the San
Francisco Fed concluded a detailed review of some of the most highly
concentrated banks that we supervise. They found that loan quality
and underwriting is good
overall, but concentration risk management practices are weak. For
example, management and directors at most of these banks did not formally
their concentrations in their strategic or capital planning, nor did
they have reports that give them a portfolio-wide view of their risk.
The San Francisco
Fed has communicated our expectations around high commercial real estate
concentrations to the banks we supervise, and we’re now at
the early stages of developing potential interagency guidance.
high concentrations at banks in the west—and California in
particular—we give considerable attention to commercial real
estate market conditions. The good news is that we’ve seen
a decline in office vacancy rates around most western markets since
year’s highs. But
something we’re keeping an eye on is the lagged response in
net operating revenues for commercial office and industrial space.
could lead to rising
bank loan delinquencies and charge-offs. On the plus side, lower
mortgage rates help ease cash flow pressures, and gains in employment
rental rates going forward.
Another issue on our radar screen is
rapid growth at many western community banks. For example, total
loan growth at California commercial
averaged twenty-two percent in the past year, excluding new banks.
High growth can
outstrip a bank’s capital and internal control structure,
and we’ve seen
banks offer new products and services without formally analyzing
the risks and implementing required control and audit processes.
in a stronger economy could add stress to the existing control
environment and management capacity at some banks. Advances in
productivity certainly help support growth, but banks often tell
us they’re “doing
more with less,” and some may be tempted to cut corners imprudently.
We’ve already seen this in some cases.
Another concern related
to loan growth is the easing of credit standards and terms on
loans. We expect to see this in an economic
and recent Fed Surveys on bank lending confirm that this is occurring.
somewhat troubling that one of the reasons banks indicated they’re
easing credit conditions is increased competition from other
banks and non-banks.
The rising interest rate environment is
also on our radar screen.
Even though banks have made considerable advances in managing
are a few things we’re watching. First, some borrowers
may have difficulty meeting higher payments on variable-rate
who already have built up a high level of debt burden. That
said, the potential impact on banks should be limited because
loans are at such a
low level right now, and because of offsets from a stronger
economy. A more significant supervisory concern with the rate
is that while many
banks are understandably positioning their balance sheets for
shortening asset durations, for example—some are not
considering alternative scenarios with respect to the shape
of the yield curve and the timing of rate
changes, and we’ve already seen how the bond market and
long rates have fluctuated in reaction to some of the economic
uncertainties I mentioned earlier.
A related issue is the potential
impact on liquidity. While deposit growth has held up reasonably
well, funding may become
seek higher returns. Banks have many more funding options
available today than in the past. But rising rates will test banks’ interest
rate risk management and funding strategies, especially if
loan demand jumps concurrently. And though
most banks—even small community banks—are
using sophisticated techniques such as Economic Value of
earnings simulation, some banks
fall short by not fully understanding their models, by failing
to validate assumptions on a regular basis, or by using a
model that doesn’t support
the size and complexity of operations.
The final issue I’d
like to touch on is the compliance environment. As I said,
I am sensitive to the regulatory burden, and I do appreciate
of heightened attention in several areas such as bank secrecy,
anti-money laundering, the Sarbanes-Oxley Act, and various
consumer regulations. Regulatory compliance—in
a broad sense—is on our radar screen because we’ve
seen some banks increase their focus on growth and efficiency
so much that elements of
their compliance programs slip. This has happened not only
because the desire to reduce costs has made it tempting to
cut corners, but also because some
banks have not fully appreciated how growth in size and complexity
requires a more robust compliance program.
As you know, the
banking regulators have had a longstanding role in assessing
compliance with various safety and soundness
well as consumer
At the Federal Reserve, compliance is an essential component
in our evaluation of a bank’s internal controls and
risk management framework. Some recent laws have expanded
the focus in certain areas—for example, the Patriot
Act and SOX 404. But our fundamental role hasn’t changed.
What has changed is the environment. Today, weaknesses in
a banking organization’s internal
control structure and compliance programs translate not only
to significant operational risks but also to considerable
legal and reputational risks.
In closing, I want to emphasize that we don’t think widespread problems
are likely. Some banks will probably see fallout from the risks I mentioned
as well as from others that I didn’t discuss. But industry conditions
in many respects are stronger now than they’ve ever been. That undeniable
fact, together with the advances in risk management I talked about, put the
industry overall in a solid position to deal with any challenges that may arise.
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