The increase in the prevalence of interest-only loans and the introduction of more-exotic forms of adjustable-rate mortgages are developments of particular concern...Some households may be employing these instruments to purchase homes that would otherwise be unaffordable, and consequently their use could be adding to pressures in the housing market.  Moreover, these contracts may leave some mortgagors vulnerable to adverse events.

We need to keep in mind that most measures designed to protect consumers from bad credit market outcomes also raise lending costs and can prevent them from obtaining credit in the first place...Having said that, policymakers should be alert for opportunities to reduce adverse outcomes without harming credit availability – in other words, to improve the terms of the trade-off between credit availability and borrower protection.

While some policies that carefully target truly abusive practices are warranted, the broader risk is of a regulatory overreaction that stifles much of the benefit of the technology-driven expansion in consumer credit.

Dramatic improvements in credit availability are accompanied by predictable increases in the incidence of delinquencies and abuse, as new products proliferate and new borrowers are drawn into the market. The spread of adverse outcomes inevitably triggers calls for new regulatory constraints on lenders. But while truly abusive practices certainly deserve regulatory attention, policy measures that impede the functioning of credit markets need to be approached cautiously to avoid an overreaction that stymies much of the benefit of the innovations in retail credit practices.

As the real estate lending cycle matures and lender competition increases, banking supervisors tend to worry. In particular, in the commercial and residential real estate sectors, we worry that borrowers could become increasingly speculative, buying beyond their means and hoping for asset price appreciation--whether they are buying for their own use or strictly for the sake of investment. We worry that competitive pressures could drive banks to lower their underwriting standards, implicitly encouraging such speculation. And we worry that, in the inevitable downturn, credit quality could deteriorate to the extent that some banks could experience significant losses.

The business sector and business investment spending have been strengthening as the expectation of further growth has permeated the marketplace. In this environment, the demand for commercial loans has begun to accelerate...My sense is that there is keen competition among banks to make these loans. Under these circumstances in the past, banks tended to underprice risk. It is particularly important to guard against this temptation, particularly because slackening growth in deposit inflows may put upward pressure on funding costs as the expansion progresses.

[Commercial real estate lending] accounted essentially for all of the asset growth at these institutions in 2003 and 2004...There is no indication at this time that the overall credit quality of CRE exposures at community banks has deteriorated, although there are signs that some underwriting standards have been under assault from competitive pressures.

As economic conditions and business loan demand have improved, we have expected and seen some degree of easing in commercial lending standards.

Supervisors have been attentive to indications that home equity lending standards and risk-management practices may not have kept up with the very rapid growth in this form of lending. Last month, the federal banking agencies issued guidance to the industry that was aimed at reinforcing sound practices for lending and credit risk management. I encourage bankers to review that guidance and consider its recommendations carefully.

Underpriced access to central bank credit will of course distort private sector choices. Absent countermeasures, banks will take excessive risks and central bank credit will be overused, a distortion often referred to as moral hazard.

The potential for moral hazard due to a public sector safety net, and in particular the provision of central bank credit in connection with payment operations, is to my mind the central rationale for central bank oversight of payment system participants...It is my sense that central banks have not come close to fully offsetting the safety net’s moral hazard distortion, although I would be hard pressed to document that claim, except to note the extent to which access to central bank settlement seems to be highly prized by financial institutions. 

The relation of central bank credit to the broader public safety net has implications that are sometimes overlooked. For example, the collateralization of central bank credit extension may reduce risks to the central bank, but it can increase risk to the deposit insurance fund. Therefore, the central bank ought to consider more than just its own balance sheet risk in making lending decisions. This is especially important because, as the lender of last resort, the central bank can often force an institution’s closure by refusing credit.

[The staff at the San Francisco Fed] found that loan quality and underwriting is good overall, but concentration risk management practices are weak.

It’s somewhat troubling that one of the reasons banks indicated they’re easing credit conditions is increased competition from other banks and non-banks.

As in the past, without strong risk management and credit discipline, the prolonged period of favorable conditions could breed behavior by lenders that will contribute to a more severe credit cycle the next time around.