Let me suggest three factors that can contribute to {credit market} overheating. The first is financial innovation. While financial innovation has provided important benefits to society, the institutions perspective warns of a dark side, which is that innovation can create new ways for agents to write puts that are not captured by existing rules…

The second closely related factor on my list is changes in regulation. New regulation will tend to spur further innovation, as market participants attempt to minimize the private costs created by new rules. And it may also open up new loopholes, some of which may be exploited by variants on already existing instruments.

The third factor that can lead to overheating is a change in the economic environment that alters the risk-taking incentives of agents making credit decisions. For example, a prolonged period of low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risks, or to employ additional financial leverage, in an effort to "reach for yield."

I expect the financial system to continue to involve a mix of capital markets and institutions, but with a wider array of institutions falling under regulatory supervision. Furthermore, I take it as given that there will continue to be large international institutions with operations in many countries, that is to say, regulatory jurisdictions around the globe.

Looking ahead, I see an ongoing role for securitization and the originate-to-distribute model. Securitization markets have shrunk dramatically over the last year and a half and in some cases have shut down altogether. I expect these markets to return, perhaps in simpler form and with more accountability.

Financial crisis can serve as a powerful stimulant to the evolution of market mechanisms, and I expect that the aftermath of the present turmoil will see both innovation and incremental refinement to quality assurance in credit markets and in counterparty credit risk management.  I would like to highlight two themes that I believe will influence this process.

First, for quality assurance to be effective, some of the products traded in financial markets have to become simpler and more transparent.

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A second key factor for effective quality assurance relates to the institutional and contractual framework for ensuring future performance on financial transactions, namely counterparty credit risk management.  Counterparty credit risk management should be focused on its effectiveness in different market situations and its implications for financial stability.

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(I)t is not just the banking industry, but also those of us in the public sector who have some key lessons to learn.  Banks and supervisors alike need to undertake additional work to facilitate the building of robust methods of quality assurance in the financial markets that will help to restore and maintain confidence.  Ensuring that banks exercise good risk management, of course, is an important job for bank supervisors, which includes overseeing their ability to properly capture the risks in the markets in which they operate, as well as their ability to conduct appropriate stress testing to explore potential consequences of different types of market distress.  Doing so requires that supervisors themselves develop a strong understanding of the value, limits, and potential harms associated with banks' attempts to protect their exposures.

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...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.

Credit is threatening to displace liquidity as the primary antagonist. A credit crunch, particularly for small businesses and consumers, poses meaningful downside risks to the real economy. And market participants are struggling to assess the possibility that the narrative turns into a multi-act, macroeconomic drama.

Market participants now seem to be questioning the financial architecture itself. The fragility of short-term credit markets is a powerful manifestation of that loss of confidence. There are some encouraging, early signs of repair, but regaining the confidence that markets require will take time, and perhaps uncomfortably to some, patience. It may also require new forms of credit intermediation.

The case for opportunistic capital is improving. Some curative steps by incumbent financial institutions are in the offing. Financial institutions should continue to reassess their sources and uses of funding, their risk-management systems, risk tolerance, and human capital. Generally, they should not hesitate to pare their dividend and share repurchase programs. And, they should raise new capital to strengthen their balance sheets. These actions, in my view, are important signs of strength, and will ensure that financial institutions thrive in the emerging financial architecture replete with new opportunities. These actions will have concomitant benefits on real economic activity.

Thus far, the quality of other consumer loans has remained satisfactory. However, the delinquency rates on credit cards and consumer installment loans at banking organizations increased over the second half of the year. Moreover, although household bankruptcy filings remained below the levels seen before the changes in bankruptcy law implemented in late 2005, the bankruptcy rate rose modestly over the first nine months of 2007 and could be a harbinger of increasing delinquency rates on other consumer loans. In view of this risk, Federal Reserve supervisors are monitoring these consumer loan segments for signs of spillover from residential mortgage problems, particularly in regions showing homeowner distress, and are paying particular attention to the securitization market for credit card loans.

I have spoken elsewhere of the secular expansion of consumer credit, including mortgage credit, and have argued that it has been the result of a broad wave of innovation.  The evidence strongly suggests that most of this expansion of credit can be accounted for by falling transaction costs associated with lending and borrowing. ... The cost reductions that have driven the growth of consumer credit can best be understood as the result of improvements in the ability of lenders to collate and analyze information about consumers, which in turn has allowed lenders to differentiate more finely among borrowers.  As innovations progress, the allocation of credit moves "down the demand curve."  The new borrowers brought into the market by these developments will, on the whole, have higher than average risks.
 

The expansion of retail credit has brought an increase in what one might call “bad outcomes” — households that face high debt burdens, have trouble meeting payment commitments, and perhaps even default and resort to bankruptcy.

The federal banking agencies have recently proposed guidance that would focus examiners' attention on those loans that are particularly vulnerable to adverse market conditions--that is, loans dependent primarily on the sale, lease, or refinancing of commercial property as the source of repayment.  I emphasize that, in proposing this guidance, supervisors are not aiming to discourage banks from making sound loans in commercial real estate or in any other loan category. Rather, we are affirming the need for each bank to recognize the risks arising from concentration and to have in place appropriate risk-management practices and capital levels.

A bank with significant concentrations may need to both strengthen its control environment and hold capital well above regulatory minimums. In certain cases, it may be prudent for an institution to reduce its concentrations. This is particularly important, since CRE lending in recent years has occurred under fairly benign credit conditions and, naturally, those conditions are unlikely to continue indefinitely.

Nontraditional mortgage products have been available for many years; however, these types of mortgages were historically offered to higher-income borrowers only. More recently, these products have been offered to a wider spectrum of consumers, including subprime borrowers who may be less suited for these types of mortgages and may not fully recognize their embedded risks.

Many markets may perhaps be underpricing risks going forward.  Events of policy mistakes that heighten perception of risks could significantly alter current conditions.  In this regard, a resurgence in inflation could alter expectations about the path of short-term interest rates.  Signs that higher oil prices are weakening growth, along with the maturing of the credit cycle, could alter perceptions about credit quality and widen credit spreads.

Overall, the banking industry is healthy. However, some issues warrant the attention of bankers and their supervisors. One credit risk management issue that has been in the news quite a bit lately is home mortgage lending, particularly the surge in originations of nontraditional mortgages...Banks' risk management procedures must take into account the unique characteristics and credit risk profile of these novel types of loans, especially because our experience with them is quite limited.