Prudential regulation coupled with good risk management meant that financial firms limited their exposure to risk during the boom years of the late 1990s. This approach paid off handsomely when the asset-price break occurred. Despite the recession, banks remained well capitalized, and their strength eliminated the threat of a vicious credit crunch or the risk of fragility in the system.

In my judgment, the only way for financial institutions to insure stability in the event of nonquantifiable shocks is for them to maintain a substantial extra capital cushion above that deemed necessary by analysis of quantifiable risks.

As our economy expanded, business and household financing needs increased and projections of future outcomes turned increasingly optimistic. In such a context, the loan officers whose experience counsels that the vast majority of bad loans are made in the latter stages of a business expansion, have had the choice of (1) restraining lending, and presumably losing market share or (2) hoping for repayment of new loans before conditions turn adverse. Given the limited ability to foresee turning points, the competitive pressures led, as has usually been the case, to a deterioration of underlying loan quality as the peak in the economy approached.

That said, a growing dependence on wholesale funding is becoming an established trend for large and small institutions alike. As loan growth has greatly exceeded that of deposits, liquidity benchmark ratios such as loans-to-deposits have reached historic peaks.